Why investors should ignore the Fed

Posted by on April 19, 2012 @ 3:00 pm in Economy & markets

On December 16, 2008, the Federal Reserve cut its target for the shortest-term interest rate to nearly 0%. The Fed’s bold policy action was one of many aggressive steps taken to stabilize global financial markets and a U.S. economy that was in freefall. The Fed’s goals have been clear: prevent broad-based wage deflation, lower borrowing costs, rouse investors’ animal spirits, create incentives for risk-taking and, ultimately, investment in new ventures that would create new jobs, the engine of a self-sustaining recovery.

The results thus far: The level of real (inflation-adjusted) GDP now exceeds pre-recession levels (when short-term rates were above 4%). The U.S. stock market is approaching its pre-crisis levels. And the U.S. unemployment rate, while still unacceptably high, is falling. The Fed’s zero-interest-rate-policy, or ZIRP, can’t account for the entire improvement in financial and economic conditions, but the recovery would almost certainly be weaker without it.

Benefits, costs, and risk

As with all policymaking, ZIRP is about tradeoffs—benefits and costs. The Fed intends to keep short-term rates near 0% at least through the end of 2014, a strong commitment that markets have internalized as a near certainty. As such, it may be time for policymakers to devote more attention to ZIRP’s costs and risks. At some point, ZIRP’s benefits will no longer outweigh its aggregate costs.

One visible cost is the price paid by savers, the proverbial “sacrificial lambs” of ZIRP. Since peaking at $1.4 trillion in August 2008, the annual rate of personal interest income has declined by more than $400 billion*, as the yields on short-term bond funds, money market funds, and bank CDs have plummeted. This translates into a decline of nearly $1,000 in disposable personal income per person, although the lost interest mostly impacts older Americans. The modest economic growth the nation has experienced since 2008 has come, to some extent, at the price of a negative real rate of return for savers—0% interest rates minus an annual inflation rate of 2% to 3%.

Although less obvious than the cost of lost interest income, the Fed’s telegraphed commitment to ZIRP through 2014 poses new risks to investors. As the manager of more than $1.8 trillion, Vanguard is seeing assets move from short-term bond and money market funds and into higher-yielding—and riskier—segments of the bond and stock markets. This marked increase in risk-taking within major asset classes is sometimes masked in aggregate cash flows, yet it has been occurring with increasing force across the mutual fund and ETF industry. A prime example of increased risk-taking involves bond funds. Over the past three years, taxable bond funds have attracted more than $650 billion in net cash flows according to our calculations of Morningstar mutual fund and ETF data. Yet the vast majority of this bond cash flow has been concentrated in higher-yielding (and longer-duration) fixed income categories, including intermediate-term bonds ($250 billion), as well as international and emerging-market bonds (over $100 billion). At more than $56 billion, the cash flow into high-yield bond funds has dwarfed that for ultra-short and even plain-vanilla U.S. government bond funds.

The search for yield is increasingly found in the stock market, too. Equity-income funds and ETFs have attracted more than $30 billion (and climbing) over the past year alone as investors search for income-producing assets, despite the fact that dividend-paying stocks are not bonds. This asset-allocation shift from lower-yielding to higher-yielding and more volatile assets is consistent with Fed policy. Unfortunately, it may not be consistent with investors’ long-term goals.

Consider investors who are asking their mutual fund providers and financial advisors about moving assets from a short-term bond fund into junk bonds or high-yielding stocks in a desperate search for income. If those riskier assets experience a correction, as they almost certainly will, will these new risk-takers be prepared for the turbulence? Or will they sell, sabotaging savings and investment programs designed to help provide a more comfortable long-term financial outlook? Are investors becoming too complacent in reaching for yield, interpreting ZIRP as an iron-clad promise, rather than as a forecast that can change with economic conditions?

From a macro perspective, could ZIRP be creating new bubbles (via lower interest rate uncertainty and increased leverage) that will make a market correction more violent? And by attracting more capital into ever-riskier investments, is ZIRP now working so well that it has made its eventual exit that much more difficult? At Vanguard, we don’t think anyone can know for sure, but it’s time for policymakers to revisit the questions.

Don’t fight the Fed. Ignore it.

In the meantime, our counsel to investors worldwide remains unchanged. Make sure you have a plan for reaching your investment goals. For most investors, a sensible plan includes a mix of stocks, bonds, cash, and perhaps other assets. Even as short-term interest rates hover near 0%, cash and bonds still play a critical role in helping to moderate a portfolio’s ups and downs. Keep costs low. And unless your goals and circumstances have changed, resist the urge to react to Fed-engineered rallies in riskier assets. The old Wall Street adage says “you can’t fight the Fed.” Maybe not. But you can ignore it.

* Source: U.S. Bureau of Economic Analysis

Notes: All investments, including a portfolio’s current and future holdings, are subject to risk, including the possible loss of principal. All investing is subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss in a declining market. Because high-yield bonds are considered speculative, investors should be prepared to assume a substantially greater level of credit risk than with other types of bonds.Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

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