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You Asked, We Answered: How Could Rising Rates Hit Markets?

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November 3, 2015
How rising interest rates could affect the stock market.

Craig Laffman, director for fixed income and syndicate, joined JJ Kinahan, chief strategist at TD Ameritrade, for a September webinar that tackled market implications from potentially higher interest rates. Of course higher rates will kick in only once the Federal Reserve removes recession-linked ultra-loose monetary policy—a moving target on the calendar.

The guys’ chat generated great questions from the listening audience. And while the markets have quieted a little since September, nervousness and potential opportunity surrounding higher rates haven’t gone away. Craig addresses some of the topics you’re most curious about.

Q: How can retirees stay invested while managing market risk with the potential impact of interest rates?

A: Retirees tend to be more focused on generating income and preserving their wealth. Retirees might limit, or mitigate, risk by considering investing in bonds or certificates of deposit (CDs) that mature within a couple years. For bonds, it’s imperative that investors understand and are comfortable with the issuer and its credit worthiness because it’s equally important for income investors to focus on credit risk as interest rate risk. Retirees could also consider buying a bond ladder—buying bonds with varying short-dated maturities. As a bond matures, an investor can reinvest that money at the current market rate.  

Q: Explain the relationship of the 30-year Treasury rate to a Fed interest rate hike.

A: It is imperative for investors to understand duration—an instrument’s sensitivity to interest rate changes. The long end of the yield curve, where the 30-year sits, tends to be more sensitive to inflation and overall economic growth. The short end is more immediately sensitive to changes in the Fed Funds rate. That doesn’t mean that holders of the long bond are insulated from Fed activity; rate changes can be reflected along the yield curve as investors adjust their expectations for inflation and economic growth. Among key metrics under the Fed’s watch, the panel has said it needs to see evidence of meaningful inflation prior to an increase in the Fed Funds rate.  

Q: What is the likely impact on Treasury Inflation-Protected bonds (TIPs)?

A: This is not a simple answer as it’s a complicated question. TIPs do react differently than traditional bonds and their market prices can move substantially with changes in interest rates. TIPs are generally purchased to provide a hedge against inflation and that’s the important distinction to keep in mind. The impact on a TIPs will really depend on the level of inflation and what impact Fed activity has on the real, or inflation adjusted, yield.  If inflation is on the rise (and by how much) and rates rise, then TIPs would experience a smaller price decline than a traditional bond. If rates rise but inflation is stagnant, then TIPs and traditional bond holders would experience price declines.

Q: To what extent do Treasury yields influence municipal bond yields? 

A:  Municipal bond yields tend to follow the Treasury market. Municipals bonds historically trade at a percentage of and tend to be more buy-and-hold fixed income investments than taxable equivalents. They can trade much less frequently than other traditional bonds. That doesn’t mean that price volatility won't be experienced when rates rise, as that’s the general reaction across all fixed income. But it is worth noting that the funding source of the bond (taxing authority, toll road, etc.) won’t likely be significantly negatively influenced by rate hikes. The cost of issuing new debt will likely rise and that in turn could negatively affect the price of secondary offerings. Like every bond, it’s important to be comfortable with the creditworthiness, maturity, and coupon, plus understand the duration risk tied to a particular municipal bond.  

Q: It seems to me that an interest rate increase at this point is the result of an improving economy as opposed to risky inflation. My question is how much “market bubble” inflation might be removed by a quarter-point Fed rate increase? With rates so historically low, could a modest increase only pull a little money out of stocks? Is there something about margin account pressure that I am missing? Better investments? Irrational exuberance?

A: The markets likely could digest a quarter-point Fed Funds hike. However, many industry economists still believe that the risk of raising rates too soon outweighs the risk of waiting too long. The reality is that this is an unprecedented situation for this or any Fed. In their attempt to be transparent around communication, they’ve probably been too transparent, leading to confusion and mixed messaging. It’s not so much the first hike that could baffle the markets as understanding the timetable thereafter.

Fed-rate-history

FIGURE 1: BRUSH UP.

It’s been a while since the U.S. was in a rate-hike cycle. Investors and consumers may need to refresh their understanding of interest rate changes and the impact on markets and the economy. For illustrative purposes only. Past performance does not guarantee future results.