Gil’s Musings

The Fed’s Bait on Rates

Federal Reserve Chairwoman Janet Yellen played coy during her testimony before the Senate Banking Committee Tuesday. She hinted that the Fed may begin laying the ground work for an interest rate increase later this year. Don’t bet on it.

The U.S. has been on a stimulative path for seven years now, with interest rates hovering near zero. This has boosted the markets and aided the growth of financial assets, but it’s come at the expense of savers who count on bank returns for survival.

The prolonged zero-interest-rate environment has also revealed strikingly anemic demand for business loans despite super cheap money. Debate about the demise of the zero-interest-rate policy has stirred since the Fed first adopted it, and testimony like Yellen’s only stirs the pot anew.

But the idea that the Fed will have cause to raise rates anytime soon is wishful thinking. Unemployment has remained stubbornly high – one-third of the states still surpass the 6% threshold — and the 5.7% reported rate for the U.S. in January is deceptive because those who give up on finding a job are suddenly counted as “retired.” Obamacare and rising taxes are more cold economic water.

All the speculation about higher rates seems to be driven by politics and government denial about our economic reality. The federal government is still running mutli-trillion-dollar deficits on an aggregate basis. It borrows to cover that shortfall and pays interest on the debt, so how excited can government officials be to see rates rise? The only benefit in moving away from zero interest at this point would be to convince everyone that we are back to normal.

In addition, the Fed needs rates a tad higher so it can use rate cuts in the future as a tool for economic stimulus.

Meanwhile, the dollar is strong as foreign governments weaken their own currency in a desperate move to boost trade. A weaker currency at home makes their goods cheaper in international markets. But this happens at the expense of U.S. manufacturers. Hiking interest rates will only stimulate an additional influx of foreign investors who profit from having dollars and investing in U.S. bonds.

As if all that weren’t gloomy enough, collapsing oil prices further strengthens the argument that inflation is dead.

As the debate heats up, investors should begin the process of lengthening maturities of fixed income into the volatility in bond prices that’s likely to ensue. Select levered, closed-end funds, which borrow or pay dividends at short-term rates and use the money to invest in strategies with longer-term returns. These are likely to benefit from the snapback in prices. But beware of limited liquidity in these vehicles. Individual bonds always offer a return of your principal – just in case I’m wrong and you wait it out to maturity.

Funds rarely offer this feature because only a few actually mature like a bond. Funds also incur costs that bonds generally don’t. They tend to own even longer bonds to have higher yields disguise that fact. This can make the bond funds even riskier.

These steps will help you prepare for an eventual increase in rates, whenever that may be, with falling victim to the latest political rhetoric. Rate hikes may come, but at the moment they don’t seem sustainable.

Please see IMPORTANT DISCLOSURE information

Subscribe to Gil’s Musings

Sign up to receive Gil’s periodic musings about investment trends, the stock market, investor behavior and current affairs. Join today and receive a handful of Gil’s favorite past musings, and be the first to receive his freshly penned thoughts

  • This field is for validation purposes and should be left unchanged.