What’s Up With the Fed and Interest Rates?
I asked a friend for one thing they always wanted to know about finance…
And he responded with: “How are the Fed, interest rates and the stock market linked?”
This topic gives me a headache sometimes. Why? It’s nearly impossible to explain how the Fed functions succinctly — it could take days, even weeks. These are the books I’ve read that are more or less about the Fed and macroeconomics and monetary policy in the last couple of years:
If anyone was able to explain the complex, dynamic array of causes and effects and perverse incentives and feedback loops caused by central bank policies…
Not another drop of ink would need to be spilled on the subject.
Yet here we are.
The other reason this topic isn’t easy to discuss is, even if I were to somehow sum it up, you’d say, “Wow, that’s really boring and I don’t see how it affects my life”…
That’s the thing, though…
It actually does.
But this happens indirectly, so we don’t actually see the Fed’s decisions impacting our lives.
Part of the reason is that no one seems to agree about what the role of the Fed is, or what it should be, or even whether “The Fed” should exist. Certainly not politicians or the former chairs of the Fed!
So to the average person, the Fed can seemingly create or destroy trillions of dollars out of thin air.
A cynical person might even assert that “The Fed is printing money” or joke that “Jerome Powell makes the money printers go brrrrrrrrrrr”…
But it all feels very abstract. We read “the Fed has created $6.5 trillion” on paper… yet we don’t feel like that money is appearing in our wallets.
In reality, monetary policy has little if anything to do with “money.”
Many contemporary economic models barely even mention or address “money.”
It has everything to do with interest rates, or the amount institutions charge each other and you for loans. This is called the “Effective Federal Funds Rate”...
And that is where you can see how the Fed’s decisions can impact your wealth.
Take a look at this chart:
The blue line is the Fed funds rate, and the orange line is the 5 year price returns for the S&P 500. (The gap in the beginning is due to the fact that you can’t have “5 year returns” until five years have passed.)
The correlation between these two sets of data is 0.05.
No connection whatsoever. There’s seemingly no relationship.
But now look at this chart:
The blue line is still the Fed funds rate — the percentage is on the left.
But this time the orange and gray lines represent the 5-year future returns of the S&P 500 and the Nasdaq, respectively. The gains are on the right.
Stick with me… I promise this’ll all come around in a few paragraphs.
That means, if you bought market-tracking ETFs (like SPY and QQQ), you would have seen about 102% returns in five years from the S&P 500 and 184% from the Nasdaq, not including dividends.
(The gap at the end is due to the fact that you can’t have “5 year future returns” until five years have passed.)
We’re starting in the year 2000, around the tech bubble collapse, when Fed chair Alan Greenspan began actively using the federal funds rate to aggressively lower interest rates to fight the deflation of asset price bubbles and support the economy.
This policy has continued.
So what do you think happened?
The price of these stock indices move in almost the exact opposite direction as the Fed Funds rate now.
The correlation between the Effective Fed Funds rate and the future returns of the S&P 500 is -0.76, and the correlation with the Nasdaq is -0.75.
One way to wrap your head around this is: When Fed interest rates go down stocks go up. And vice versa.
Another way to think about this is: When the Fed makes it easier for everyone to get cheaper loans, it takes about 3 to 5 years to impact asset prices, such as the stocks in your retirement account.
And a final way to think about this is: With the Effective Fed Funds rate at 0.07% and the heads of the Fed talking about “tapering” and raising rates…
The evidence suggests that we should expect the returns from major market indexes over the next five years to be pretty mediocre or negative.
This is just another reason, on top of the concern I shared last week, that I think the party in the investment markets is going to be on pause for a few years.
Especially for “safe,” long term passive index investing.
“SO HOW DO I INVEST IF INTEREST RATES CLIMB?”
There are three stock investment strategies that are likely to win out over the next 5 to 10 years if interest rates creep up and the economy stagnates:
Dividends — Investments that pay you regular cash income, regardless of what the market does.
Uncorrelated Assets — These are investments where the price does not move in connection with the overall market. So if the market tanks, these assets might stay stable or go up in value.
Active Investing — Good, old fashioned, run of the mill stock pickin’.
To achieve the first two, I like the iShares Preferred and Income Securities ETF (NASDAQ: PFF).
This ETF holds a basket of what are called “preferred shares” for stocks, which are a kind of corporate debt. So when you buy a share of PFF, it’s like you’re buying a bond that pays you a little bit every month.
The last one, Active Investing, is a whole other bag of burritos, and a topic for a future issue. In fact, I’m currently working on my first product for DIYwealth that’s designed to help you do this, but I will tell you more about that later.
