Countdown to Liftoff: The Fed’s Interest Rates and What It Means for 2016
Anyone in the finance industry is familiar with this ongoing saga. Since Ben Bernanke dropped interest rates to essentially 0% in the midst of the recession, analysts and economists have been weighing in on when the Federal Reserve would start to raise rates. Many have been predicting such an action since 2011 and been wrong every time. Finally, with unemployment at 5% and job growth looking strong, there seems to be a 90% consensus among analysts that rates will rise when Janet Yellen holds her news conference on December 16th.
What is this interest rate, why is everyone obsessing over it, and what does that mean for the average investor?
This graphic shows the Federal Funds Target Rate previous to the December 2008 rate change; since then, the upper limit of the Federal Funds Target Range has been zero to 0.25 percent. Source
To simplify, the federal funds rate is what banks can charge each other for overnight loans. When the economy is strong, the Fed raises rates to offset its own balance sheet. When inflation is high, the Fed will also raise rates to rein it back in. However, when the economy is weak, rates will drop. This makes taking out a mortgage, auto loan, or business loan much cheaper, essentially encouraging the market to borrow, buy, and invest into the economy. Many would argue that the Fed chair (Ben Bernanke when rates were dropped, and Janet Yellen today) has more power over the state of the economy then the president has with their fiscal policy.
In a “traditional” economy, when rates are low and the Federal Reserve is printing money, one would expect inflation, meaning the cost of your average goods would go up. But the odd part of these past seven years is that we have seen very little inflation: oil prices have gone down which lowers the prices of other goods, and an ever increasing global economy has made access to markets with lower labor costs and tax rates much easier. Thus, the Fed hasn’t been pushed to raise rates. While there are still some economic factors such as wage growth that are not doing well, most indicators leave analysts saying that if we don’t raise rates now, when will we ever raise rates again?
In a “traditional” economy, rising rates have meant a downturn in the market. To oversimplify again, borrowing would decline as it becomes more expensive, thus making it more difficult to expand a business. The debate today seems not to be when will rates rise, but how fast will they rise in 2016? After all, raising the lowest interest rate from 0 to 0.25% should not have a major effect on the economy, but what if rates become 3-4% in too short of time? Meanwhile, with the global markets lagging, the European Central Bank (ECB) LOWERED their rate to -0.3% last Thursday, putting pressure on the Federal Reserve to keep rates competitive.
So what does this mean for you? Volatility. After relatively quiet years from 2012-2014, we started to see larger spikes and plunges in September after concerns in China put another layer to monitor onto the interest rate narrative. Many day traders watch the Federal Reserve meetings with a keen eye on where interest rates are going, and the institutional money has been making bigger waves in the market. Despite that, once the waves settled, we found ourselves up 3.6% in the S&P 500 for 2015 as of Monday morning. P/E ratios sat at 16.45 against a historical average of 16.6.
My recommendation? Hold your nose and do nothing. You should understand that rising interest rates are a result of a stronger economy, and with valuations of the market still in check, there is still room for the bull market to run. But speculators are going to have their say, and 2016 could be the rockiest year since 2008. If you’re desperate to actively manage your account and make a play, this site makes some recommendations on how to go long on the VIX, the standard measure for volatility. However, that would not be my recommendation. Instead, stay with the asset allocation that you and your adviser laid out based on your risk tolerance and time horizon, just be ready for a little bit of motion sickness in 2016.