As the markets waited for Jerome Powell to be sworn in to his role as Chair of the Federal Reserve, taking over from former Chair Janet Yellen on Feb. 5, 2018, many were wondering how he would approach running the Federal Reserve, and how that could ultimately impact different asset classes.
It’s natural to focus on the Fed Chair. After all, they are typically few and far between (see below), and, as the head of the nation’s central bank, they have a lot of influence on the U.S. economy.
But, beyond the Fed Chair, the overarching thing that is important that the Federal Reserve is in charge of is U.S. monetary policy—the supply and rate of growth of money. The Fed’s monetary policy impacts equities, bonds, real estate, commodities, and currencies—pretty much anything you can invest in. Therefore, it’s probably a good idea for investors to have at least a basic understanding of the Fed and the monetary-policy environment we’re currently experiencing.
The Fed and Monetary Policy
In the case of U.S. monetary policy, the three economic goals Congress has instructed the Fed to pursue are promoting maximum employment, stable prices (keeping inflation in check) and moderating long-term interest rates.
The Fed has a range of tools that it uses to implement monetary policy. Ultimately, the Fed pursues the goals Congress gives it is by managing short-term interest rates (sometimes longer-term interest rates like they did in the case of the Great Recession)and affecting the availability and cost of credit across the U.S. economy.
Monetary policy is typically expansionary (loose), contractionary (tight), or neutral. If the economy starts growing too fast and inflation speeds up, the Fed might raise interest rates and take steps to reduce available credit to slow it down, which is a contractionary or tight environment. On the other hand, if the economy is growing too slowly, or not at all, the Fed might lower interest rates and take steps to increase available credit to jumpstart growth, which is an expansionary or loose environment.
Some investments tend to perform better in times of expansionary monetary policy, while others tend to perform better under contractionary monetary policy. That’s not to say you should entirely base your investment decisions on what the Fed is doing, but it is something to take into account when thinking about your portfolio.
Expansionary Monetary Policy Environment and Investments
The Fed has started to take action to raise interest rates and move away from expansionary monetary policy. Although, with interest rates still on the lower end of the spectrum, and the Fed is still in the early stages of selling securities it was buying after the financial crisis to push down long-term interest rates (a process known as quantitative easing), we’re coming to the end of the Fed’s “easy money” approach. This is how major asset classes typically perform when monetary policy is expansionary (loose):
- Equities typically outperform. As the Fed focuses on spurring economic growth, that can bode well for companies that are able to capitalize on a stronger economy. At the same time, low interest rates and low potential returns in other asset classes might make equities more attractive to investors, helping equities to increase in price.
- Bond prices tend to rise as bond yields decline alongside the Fed pushing down short-term interest rates. Bonds will ordinarily increase in price when interest rates fall and decline when interest rates rise.
- Cash doesn’t hold up too well. The Fed’s actions to lower interest rates carry over to deposits, resulting in lower returns in savings accounts, certificates of deposit (CDs) and money-market funds.
- Commodities can increase in value, but they frequently lag other asset classes like equities. Stronger economic growth can result in greater demand for certain commodities, like copper and steel that are heavily used in construction and manufacturing industries. “One thing to keep in mind is that not all commodities are going to perform similarly. Supply and demand dynamics have a large impact on prices, something we’ve seen with oil and natural gas over the past few years. Commodities get lumped together often, but there are huge differences between metals, energy, and agriculture,” JJ Kinahan, Chief Market Strategist at TD Ameritrade, pointed out.
- Real Estate prices typically rise, helped out by low interest rates on mortgages that might spur people to buy new homes or potentially buy a more expensive house than they otherwise would’ve been able to afford.
Contractionary Monetary Policy Environment and Investments
The Fed has started to shift towards tighter monetary policy over the past several years and will likely continue to lean in that direction as long as economic data supports more restrictive monetary policy. Right now, according to Reuters, many market participants are expecting the Fed to hike interest rates three to four times this year. On a broad level, here’s how major asset classes tend to perform in times of contractionary (tight) monetary policy:
- Equities tend to underperform. Investors might be attracted to higher yields on other investments, reducing demand for riskier assets like equities. Higher interest rates can also make it more expensive to buy stocks on margin.
- Bond prices tend to fall as interest rates rise, a component of a contractionary environment. Despite often being viewed as a stable investment, investors are going to see price variations as they hold the bond.
- Cash returns can improve during tight monetary policy environments. Rising interest rates can trickle through to savings accounts, CDs, and money-market funds, making it more attractive for consumers to save.
- Commodities tend to outperform other asset classes during times of contractionary monetary policy. Although, as the Fed lowers interest rates and reduces money supply to slow down the economy, the effects can result in diminished demand for some commodities, driving down the price. Higher interest rates can also make it less attractive for companies to stockpile commodities they use as raw materials. And the rate of inflation, which often increases during contractionary monetary policy, can help increase the attractiveness of real assets like commodities.
- Real Estate tends to underperform during periods of tight monetary policy. Higher interest rates on mortgages result in a higher cost of home ownership, leading to reduced housing demand, ultimately driving down prices.
Takeaways for Investors
The above is somewhat of a simplistic explanation and, in reality, the economy and markets are constantly shifting. Oftentimes, it can take years for trends to materialize, or for the effects of the Fed’s actions to trickle through the U.S. and global economy.
Different asset classes are going to perform differently under various environments. Having a diversified portfolio across asset classes can help manage risk and make sure you’re not too heavily weighted in one area.
Regardless of the environment, Kinahan recommends that you check in on your investments on a monthly, or at least quarterly basis to ensure they are aligned with your goals and needs, as well as your overall risk tolerance.
TD Ameritrade clients can reach out to a financial consultant who can help guide you as you manage your portfolio. If you don’t have the time, or desire, to manage your own investments, another option is to look into investing solutions that offer managed portfolios to help you pursue your financial goals.
For more information on investment strategies to help weather rising interest rates, read this article on the Ticker Tape.