Interest rates: a worry for 2010
It’s still early in the new year, and there’s lots to worry about in the investment domain and in the broader world. But one item tops my “worry list” for 2010: interest rates. And it’s hard to decide which is the greater worry—the status quo, or a change in it.
The status quo for rates is simply unbearable. Money market yields are below .05%. I just rolled over a CD at 1.1%. Conservative savers and income investors are reeling.
The unprecedented level of short-term rates is of course a conscious policy of the Federal Reserve. The textbook economics argument is that low rates are needed to stimulate the economy, but overnight money at 2% would actually do the trick. Instead, today’s exceptionally low rates are a policy instrument to support the banking sector.
Thus, my bank borrows from me and other CD investors at 1%, and it is also refinancing my mortgage at 4.25%, pocketing the spread. Gains from this type of transaction are offsetting losses on bad mortgages from earlier years. It’s a great deal—an historically exceptional deal—for borrowers. (If you have a mortgage and haven’t refinanced, you should look into it—now.) But not for yield-hungry savers and investors, who are paying for the policy in the form of depleted investment income.
Over the past year, we have also seen the inevitable reaction of investors to a low-rate environment—a shift out the yield curve. Assets have poured into bond funds as investors and savers have sought higher nominal yields. Last night, as I started writing this, 10-year Treasury bonds were yielding 3.65%—not the golden 5% yield that so often catches the attention of retail investors, but certainly a lot more than 0.5% or 1%. It’s not only individual investors who have the bond bug. 401(k) plan administrators want to add bond fund options for their workers, partly in reaction to the ’08/’09 decline; managers of traditional defined benefit pensions are also shifting to bonds to manage their plan liabilities.
And therein lies the risk of a change in the status quo: a sudden rise in longer-term interest rates, and plunging bond prices. Many investors may remember 1987 for the sudden stock market crash that occurred on Black Monday, October 19. I remember the spring of 1987 instead, when bond yields soared and bond prices plunged by 10% or more over a short period. It’s not inconceivable to imagine the following scenario: The bond market—anticipating stronger economic growth, and perhaps spooked by an inflation report and a shift in Federal Reserve policy—pushes current Treasury 10-year yields to 5% in a hurry, driving bond prices lower.
Perhaps all bond fund investors are smarter than they were in 1987. Perhaps many are permanently shifting portfolios away from equities to bonds, and they plan to ride out any fluctuations in bond prices. Perhaps. Odds are, a lot of the money in Treasuries and other fixed income instruments is there because investors are thinking these investments are substitutes for cash, which they aren’t. Or investors are thinking they can time changes in interest rates and shift to cash at just the right moment, which they can’t.
Meanwhile, for all of the equity investors out there (which is most of you), here’s another wrinkle. Higher rates mean that fixed income investments become more appealing than equities, all things equal. They also mean that the prices of stocks (based on the discounted present values of future dividends) will be lower. In other words, in most scenarios, rising rates mean stagnating, or falling, stock prices.
Stocks rose sharply last year in the face of the receding risks of Depression 2.0. If rates rise in 2010, stocks will come face to face with their traditional nemesis: the “wall of worry” known as rising rates.
Pick your poison: low short-term rates making cash an unappealing option, or higher long-term rates leading to falling bond prices and stock prices. Two scenarios, none particularly appealing. My top reason to worry in 2010.
For the patient long-term investor, the strategy is to stick with your investment plan and ride out the fluctuations. Just be prepared for the bond market crisis, if it ever arrives, and steel yourself for the volatility. For the panicky investor, now is the time to revisit your portfolio—before, not after, the possible damage.
Note: All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk.
Just wanted to thank you for giving a balanced, fact supported view. I look to Vanguard for my advise.
My father-in-law lost half of his retirement by listening to fear-based-advise, and pulling out of his investment early. This economic crisis is not the end of the world, and if he would have just understood this, stayed in his investment and continued buying when the stocks were low, he’d be well ahead right now.
This quote that you said is so true, “For the patient long-term investor, the strategy is to stick with your investment plan and ride out the fluctuations.”
Well after reviewing the relative performance of all the vanguard funds for Jan 2010 the more likely senario is a double dip recession. Energy is weak mining and materials are lagging the 10% unemployment will keep purchasing power low. International is weak, europe in particular, the Euro is likely to fall against the dollar due to troubles with Greece and Spain. Commercial real estate is weak YTD due to high unemployment and problems in retail. Intermediate and Long treasuries are strong for January. So in my opinion until some serious private sector jobs are created and not the less worse reports we keep hearing, I believe your inflation senariao and fed hikes are off the table for 2010. Lets revisit the inflation high interest discussion for 2011 or 2012 I may be on board with your opinion by then. Believe me the money printing and government debt spiral will end badly, but nothing like tightening will happen in our 2010 election year.
Thank you, Steve, for this fine analysis. Your comprehensive report delinated a direction for my CD/Bond investments with Vanguard.
Great report.
That’s your worry, here’s my nightmare:
China and others are rightfully getting worried about all the money they have invested in our bond market. They see how reckless and foolishly we are behaving. They stop buying and possibly start selling our debit, our interest rates soar causing a downgrade of the U S credit rating and our interest rate to soar even more causing the US to default on our debit.
We have already been warned that our credit rating is at risk.
They have already become very outspoken about their concern over our ability to pay them back.
Our answer to them is “keep sending more good money after the bad unless you want to loose it all”
As more and more countries default on their debit, then investors will become more and more risk averse. This is how panics are created and it seems to happen every time.
I wonder if anyone knows what a panic is? Was what we experienced last year truly a panic, or just a Sunday picnic?
Once again, those of us who save and did not use leverage have to support those who spend and borrow.
Your description of the potential for rapid interest rate increases keeps me up at night as well. I agree that we folks who have looked to bonds to bring some sleep at night have had a relatively easy ride through the “Great Recession”, thus far, but are now very concerned about too much of a good thing going foward. Stocks look to be high priced, higher yielding bonds too risky, and the economy very slowly, if at all, moving forward. Trying to stay shorter term, lower duration and higher quality, leads us back to short-term treasuries or CD’s which, of course, pay very low interest rates. Better with 1% more of something than 10% less. Maybe inflation protected bonds are a reasonable play ??
I’m 67 year old and just (forced out by the economy) retired and have my entire life savings still invested in a 401K and will need to withdraw some for living expenses monthly or quarterly. I am very inexperienced at this. This is scarey as hell for me to hear.
I’m looking at spreading this out over primarily high service costed annuities (50%) and the balance over stocks and bonds. Or would it serve me better to roll it all over into an IRA (40% stocks / 60% bonds).
What are some thoughts that can be helpful to me?
Thank you.
If investing in bond mutual funds, seems the way to go is to stay balanced: some short term bond fund/s and some longer term bond fund/s. You’re right, no one knows where the bond market will end up in 2010.
I’d like to see the government step up and tell the banks getting in on the cheap overnight money that they must pay a floor rate of FFrate +2% to savers, +3% to CDs of 1 year or more. Sure it might push up mortgage rates, maybe it would cut into bank profits and bonuses, but taking money from those dependent on interest and giving it out in bank bonuses is folly. Let’s not forget the house of cards being built with those ultracheap mortgages at too low of rates. Give it five years and the banks will be back with their hands out unless those rates are returned to more reasonable sustainable levels.
Your blog is excellent. If the markets really were free it would be easier to accept the situation we are in currently. However, the Federal Reserve, I believe, is manipulating to an uprecedented degree the bond and the equities markets. They’ve trashed the money markets to make sure the banks are making money and forced people who need returns to invest in the bond markets where the Fed is purchasing treasuries to keep yields low on those as well. Soon they will stop purchasing bonds and down the road will cause interest rates to go up in the money markets thereby taking the bond returns away from those investors whom they originally forced out of money markets. Once they start raising short term interest rates, the people whom they incentivized to invest in equities will lose because the stock market will founder a bit because of higher borrowing costs. And they are already looking for a new way to game the system as far as what method they will set short term rates and then yank liquidity. And who knows what inflation will be? Free marketplace indeed.
Would appreciate Vanguard advice as well as warning.
I will stay with the Money Market Account and forego the short term bond funds because I believe the money market fund will rise in the months ahead!
Larry Summers said in Davos that 1 in 5 males in the US do not have jobs at this time. That is Great Depression era levels and has ramafications that most of us cannot imagine.
Combine that with the fact that most banks are still technically insolvent and you can see that a little bit of inflation is the least of our worries.
Ditto to whoever mentioned this above.
Thanks for the warning but I appreciate more solid advice versus the more reasons to worry.
I agree that interest rates are likely to go up – but of course the timing is always unknown. I happen to have cash to invest and the advisors I have spoken to at Vanguard suggest more diversification into bonds. But for the life of me, I can’t figure out why I shouldn’t wait on this. Isn’t treading water with cash preferable to buying bonds now at these very low rates?
I agree with those asking for advice, not reasons to worry. I can come up with reasons to worry on my own. Why doesn’t Vanguard offer bond mutual funds with fixed maturity dates so if the investor stays in the fund, they will get their principal back (adjusted for the premium or discount at time of purchase)? I know that such funds are being offered by one fund family, why not Vanguard.
Rate hikes are off the table for 2010.
Could the wise ones at Vanguard educate us on the downside of the so-called TIPS? I’m having trouble finding unbiased opinions on these ‘inflation protection’ securities. Thank you
Agree with others who desire investing advice to deal with cautions.