The Fed has publicly stated they will:
- Stop buying bonds in the open market that were adding support to our economy.
- Increase interest rates. In my opinion, perhaps 100% above what has been publicly reported.
- Start reducing their balance sheet. Many economists suggest selling $1 trillion, of the $9 trillion now held, in balance sheet assets is about the same as increasing interest rates 1%.
Trillions of dollars were injected into the economy during the pandemic. In addition, interest rates have been kept artificially low to induce borrowing and investing for economic expansion. As I wrote about in the prior Weekly Updates along the way, to get ahead of “The Real Return Illusion™” the Federal Reserve of the United States must start to increase interest rates quickly and likely more than many people are currently expecting.
If you own bonds, ask yourself why. Bond investments are like a teeter totter. Interest rates on one end (at nearly all-time low interest rates) and the investment value on the other end (at nearly all-time highs). As interest rates rise, bond prices drop. This is because as interest rates rise, investors expect to receive a greater interest rate on bonds to “keep up” with the real return. So, new bonds are issued with higher interest rates, which makes current bonds with lower interest rates becomes less valuable - who would want a bond that pays 1% when you can get a bond that pays 4%?! Thus, bonds that are currently in existence would have to sell at a discount to get someone to buy them since there are new bonds being issued with higher interest rates, which makes the current bonds with lower interest rates much less enticing to own. Should the Fed start to get ahead of The Real Return Illusion, hypothetically, a 30-year bond would drop 7 ½% in dollar value for each 1% increase in interest rates. (Source: https://www.sec.gov/files/ib_interestraterisk.pdf)
For this hypothetical example, let’s say the Fed lets rates increase to 8% from the current 2% (7.5 x 6 = 45). The 6% increase could potentially reduce the market value of a 30-year bond by -45%. That would be a realized loss of 45% should the bond holder sell.
You didn’t think that could happen?! I have seen it with my own eyes in 1983. It can happen. Take the action you need to, but start with the “why do I own this bond investment” question!
Most financial models rely on interest rates to discount a business’ future cash flow. As interest rates increase those models are likely to be adjusted. That simply means assets will be sold to reduce debt outstanding and to reduce risk in the portfolios.
It is likely this de-leveraging will continue to add volatility, both up and down, to the markets as we move into November 8, 2022, midterm elections. During the summer volatility I intend to look for long-term values that we can keep investing in as I do continue to believe 2022 is our volatile year as we transition into what could be a wonderful 2023 and beyond.
I’m interested in your thoughts, comments and observations. Feel welcome to call, email or stop by the office and say Hi.
James O. Lunney, CFP®
CERTIFIED FINANCIAL PLANNER™ Professional
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investing involves risk including loss of principal. No strategy assures success or protects against loss.
Bonds are subject to credit, market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.