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.