With the Federal Reserve set to begin its gradual interest rate hike this year, should this impact how long-term investors approach the stock market? In this segment of Backstage pass, recorded on January 26dork contributors Rachel Warren, Connor Allen and Jason Hall discuss.
Rachel Warren: The Federal Reserve released the results of its long-awaited two-day meeting earlier this afternoon. Stocks rose after the Fed temporarily released the outcome of the meeting, then fell soon after and mostly closed the day lower or flat.
One of the highlights of their announcement, they said: “The committee seeks to achieve a maximum employment and inflation rate of 2% over the long term. In support of these objectives, the committee has decided to maintain the target range for the federal funds rate at zero to one-quarter percent.With inflation well above two percent and a strong labor market, the committee expects it will soon be appropriate to raise the target range for the federal funds rate.
In short, an interest rate hike could occur as early as March. But the Fed keeps the exact timing close to the vest. Investors should expect to see an increase of a quarter of a percentage point soon. As CNBC reported, “there have only been indirect statements about when the Fed might end its monthly bond-buying program and start trimming bond holdings from its balance sheet.”
CNN also reported “asking about the potential for a half-point rate hike this year. Powell declined to commit one way or another.”
Needless to say, investors were less enthusiastic. I want to hear, what is your reaction to the outcome of this meeting? Were you surprised the Fed didn’t release an exact timeline? Do you think this is good or bad for stocks? Are you going to change anything about the way you invest based on this information? Connor.
Connor Allen: I don’t change anything. Obviously, uncertainty without a clear timeline is never really good for stocks, at least historically. But what you’re going to see from this meeting, you’re looking at the CNBC article and the quotes you see are going to talk about how Powell could take a more aggressive approach, or at least he’s not opposed to taking a more aggressive approach.
They pull out the most extreme quotes from the entire meeting. I think it’s still important to go and in fact, if you’re really interested, I don’t think I’ve ever listened to an entire Fed meeting before. [laughs] Doesn’t seem like a good use of my time.
But overall, I’m not too concerned with anything they do. I think Powell is doing a good job of trying to keep the economy healthy, and obviously the way I invest isn’t going to change based on this meeting or the resulting uncertainty.
Room: I’m having trouble finding the mute button here. [laughs] Connor, that’s the perfect answer. I think of two or three things. If you are an individual or a business operator considering taking on debt, you may need to pay attention to this to ensure you maximize your cost of capital to act quickly.
If you own a lot of bonds or are considering fixed income securities, you think about the implications for the debt that you might hold, that you might have. Maybe you have bonds that you plan to sell and that’s how you’ll raise funds in retirement. You might want to be careful because it’s more directly material.
I think there are also implications that you need to be aware of, in general. There is a relationship between stocks, especially growth stocks, and interest rates. Because the bond market is 10 times bigger than the stock market, the debt market is gigantic. It’s absolutely huge.
This means that if interest rates continue to rise and once they cross a certain threshold, there is money that is in stocks that moves to bonds because it can get a higher return safe and that this return is sufficient to reduce the risks. I think we’ve already seen this happen over the past few months. This is because it is not so much about raising interest rates, but about reducing risk. Investors won’t pay such a high multiple for growth when interest rates are higher.
It’s a reality, and it could mean you need to revise your expectations for the kind of returns stocks can generate over the next three, five, or ten years. One of our north stars is always to outperform the market. If we can’t beat the S&P500if we can’t beat the Nasdaq-100Why are we doing this? [laughs]
Why are we spending all this time, energy and effort if we can’t outperform regardless of the benchmark? Of course, it’s fun, and there’s this intellectual itch, all these things that are wholesome and good. But at the end of the day, it’s all about making money and achieving financial goals.
But sometimes I think we lose sight of what is a reasonable expectation that stocks generate in terms of return. The annualized returns of over 14% we’ve had over the past decade is much better than the long-term average of 10%. Are we going to continue to get 14%?
Or will it be 5% or 8% over the next 10 years? Reset your expectations around that, I think that’s really important. Make sure your expectations aren’t skewed, and what you think you can generate from your portfolio, and think about things like Fed minutes and what they’re talking about with interest rates and inflation and all that kind of stuff and the winding down on their buying bonds and all that.
It has implications, but it thinks longer term about what they mean.
Warren: Yeah. Well, and what’s interesting is the way they do it, it’s the slow, gradual increase. We can go back to the history of the market to see, how did it react when we saw different types of Fed policies on how they raise interest rates?
Historically, when these cycles have been slower, when there has been more equity volatility, as noted in a recent report by Schwabstocks have, although they have been more volatile, they have also fared better than in times when the Fed was just accelerating those rate hikes.
We could see more volatility. But the way they are implementing these slow but gradual rate hikes, I think, is not only designed to not just throw us into a recession, but also to mitigate the results that we might see on a variety of equity sectors .
I was a little surprised that they didn’t give a bit more concrete details. But I think equities might also have reacted negatively to this if they had.
It doesn’t change the way I invest. I think that’s something to watch out for, and we’ll see how it plays out in the months to come.
Room: I’ll share one more thing, it’ll take 10 seconds, I promise to be quick.
Warren: Go ahead, go ahead.
Room: That’s the number they’re talking about, the target federal funds rates, the upper limit. Right now it sits at 25 basis points, and that’s where they say they’re going to stick.
Every 25 basis points is 0.25%, that’s what it’s worth. We are here. Rates began to rise at the end of the Obama administration through the Trump administration before being reduced during the pandemic.
But it’s actually been very low for a long time, and that’s the big deal. Think less than 2%. Even if it continues to rise, let’s say we get 25 basis points per quarter over the next two years. This will again put us below the long-term average.
Warren: Thanks for sharing this.