The Fed currently is purchasing $80 billion in U.S. treasuries and $40 billion in mortgage-backed securities (MBS), totaling $120 billion a month.
The Fed announced that they would begin reducing their monthly purchases by $15 billion later in November, $10 billion in treasuries and $5 billion in MBS.
If the Fed stays on track, their bond purchasing program would end by mid-2022.
While the Fed’s announcement didn’t come as a surprise to many industry experts, it had an instant impact on Fed Futures and the bond market. As you can see from the subsequent charts, on September 30th there was an 83.4% chance the Fed would not raise rates at their June 15, 2022 meeting.
That probability has now dropped to just 25.7%, with the highest probability being a 25 basis point increase in rates.
The probabilities really shifted as you looked out further to the February 1, 2023 meeting (see the subsequent two charts). On September 30th, there was a 25% chance that the Fed would leave rates alone between now and then. It’s now only a 4% chance that rates will remain the same. The highest probability is that the Fed raises rates 50 basis points, or ½% between now and early 2023. There is now a probability that the Fed might raise rates by over 1% during that time.
How Does This Impact Me?
The first thing that you should understand from the Fed’s message is that they no longer feel the need to help support the economy in the same way that they have been doing since COVID struck, which is a good thing. That is why they are cutting back on their bond purchasing program, with the intent to end it by mid-2022. What the Fed Futures indicate is once they are done with their bond purchasing program, the Fed will most likely begin raising Fed Fund rates to combat inflation.
Their actions, on the other hand, can have dire consequences to your portfolio if you don’t understand how both Fed actions can impact your portfolio.
The second thing to understand is the impact on the bond market. We’ve discussed this in great detail in our webinars, podcasts, and in the Polaris Perspective pieces which we publish monthly. Both Fed actions will negatively affect the bond market, but in slightly different ways. Tapering the amount of bonds they purchase will create less demand for treasuries and mortgage-backed securities. Less demand translates into lower prices, pushing yields up. Once done with tapering, the Fed will most likely begin raising interest rates. The Fed still believes that inflation is transitory (a fancy way of saying temporary).
If inflation remains sticky due to supply chain issues found worldwide, expect the Fed to start raising rates as soon as they are done with their bond purchasing program. It would fly in the face of conventional wisdom to expect the Fed to raise rates while still buying bonds. Buying bonds stimulates the economy, whereas raising rates is done to slow the economy, thus lessening inflation. Over the next year and a half, expect the Fed to end its bond purchasing program and begin raising rates. This should drive bond rates up, and bond prices down. Please see the illustration to understand the inverted relationship between interest rates and prices.
A 1% rise in interest rates can have a meaningful impact on an investor’s portfolio. Please view the illustration provided. Imagine having a moderate portfolio allocation that had 50% stocks and 50% bonds. If you owned 50% S&P 500 like stocks, you could expect a historical return of about 9%. Let’s say the other 50% was in 10-year treasuries. If rates rose 1%, you’d lose 7.3% on your bonds. If your stocks rose at a historical rate, you’d have a 1.7% total return. You’d be losing purchasing power, with a 5% current inflation rate. Your real return would be -3.3%.
The stock market is not exempt from the impact of a rising interest rate environment. Some sectors of the markets are more susceptible to being negatively impacted. Companies that hold significant debt, especially short-term debt, could have their earnings impacted. Companies that can’t pass on the increased cost of doing business will also have their margins reduced, thus impacting their earnings. Investors should be aware that this kind of shift in interest rate policy can create a minefield of issues to try to navigate.
What is Polaris Wealth Doing?
For years, we’ve been encouraging our clients to rethink their asset allocation to limit their exposure to the bond market. While we are about to begin a rising interest rate environment, different from what we’ve seen in many years, rates have been below inflation for a long time. We have been actively managing the bond portion of our portfolios, trying to provide a return higher than inflation rates.
If you have any questions or concerns about your bond portfolio (with Polaris Wealth, or away from us), please reach out to your Polaris Wealth advisor to discuss a proper strategy. Polaris Wealth has also begun to screen all of our equity positions for their interest rate sensitivity. As mentioned prior, some segments of the market and some stocks (even in areas of the market not historically considered interest rate sensitive) are more sensitive to rising interest rates. Polaris Wealth is actively reallocating our portfolio with stocks that are either not impacted by rising rates or have a positive correlation with rising interest rates. We are building portfolios that should mitigate the impact of our upcoming rise in interest rates.