Do We Ever Really Know What to Expect From Rising Interest Rates?
In December, the Federal Reserve raised the federal-funds lending rate by .25%, only the second increase in the past decade.
The day the rate hike was announced I received several calls from journalists, all wanting to know what this means for the economy. My email inbox also started filling up with questions about the effect rising interest rates will have on real estate and stock investments.
My best answer? We never really know what to expect from rising interest rates. The core driver of all free markets is people’s behavior. And our behaviors are largely driven by emotion rather than logic. Even when we think we are being logical, we are often reacting emotionally. Daniel Kahneman’s research shows that we make 90% of all financial decisions emotionally, not logically. It took me some time to accept the truth of that research and the reality that it did apply to me, too.
Let’s consider what rising interest rates might bring to the various markets.
The first asset class we usually become concerned with is the bond market. This is where people and organizations lend money to corporations and governments, in turn receiving a fixed interest rate over a period of time that is typically 3, 5, 10 or even 30 years.
Suppose you bought a bond in which you loaned money to the US government for 30 years at 2.5%. If the going rate increased to 4.5%, you would not be very happy. You would be losing 2% a year in potential income you might earn if your money wasn’t tied up in the 30-year bond. Since the bond isn’t due to be repaid for 30 years, the only way you can get out of it is to sell it. No one is going to want a bond paying 2.5% when they can get 4.5%, so you are going to have to take a loss and sell the bond at a discount. So clearly, when interest rates rise the holders of long-term bonds get clobbered compared to shorter-term bonds.
The reverse is also true. If interest rates go down, the longer-term the bond the more valuable it becomes, as investors become willing pay a premium for bonds with a higher interest rate than the current market rate.
It's hardly surprising, then, that when interest rates are rising many advisors recommend holding short-term or intermediate-term bonds that mature or pay off in 1 to 5 years. The idea is that when interest rates rise, the price decrease of shorter-term bonds is less because of the shorter time to maturity when you get your money back and can reinvest at the higher rates.
From this you might logically conclude that, when interest rates rise, long-term bond prices always fall. Not necessarily.
Dimensional Fund Advisors carried out a case study of four periods of 12 months or more during the past 30 years when interest rates rose 1.5% or more. The periods were December 1976–March 1980 (when rates skyrocketed by 15.25 percentage points), September 1992–June 1995 (3 points), November 1998–December 2000 (1.75 points) and June 2003–August 2007 (4.25 points). Notably, in two of these four periods of rising interest rates, long-term bonds did better than shorter-to-intermediate-term bonds. In the other two periods (1998–2000 and 1976–1980), longer-term bonds did worse than short-term.
The bottom line is that we can’t depend on any markets to be logical. The bond market, like the stock market, is a free market driven by emotions. This human factor is a good reason not to take bets with your long-term investments on what the market response will be to anything.
The Cocktail Recipe for Business Success
Predicting success is incredibly difficult. Think about the NFL. The top draft picks often don’t turn into the stars of the league. How is it possible that a majority of those who follow football and are considered “smart” choose a group of players they believe will be stars and get it almost dead wrong. How do these experts miss it on Dak Prescott, Tom Brady or even Aaron Rodgers? Were there really better players?
This dilemma happens in business too. For instance, many who are hired into training programs at large financial firms are hired because of their potential to succeed. Hundreds of thousands of dollars later, less than 15% of them survive past 3 years.
Perhaps the problem is in part the raw talent. The raw talent is easy to see and may actually be a blinding factor giving false hope. What if one of the big problems with predicting success is the ability to predict someone’s ability to overcome challenges?
I don’t believe it is simply one thing that predicts success. It would be easy if it were just talent or the ability to overcome challenges. In fact, I believe that successful salespeople, professionals and yes, athletes, may result from a fully mixed cocktail of combinations. From watching some wildly successful and unrelenting professionals, it seems success comes from a mix of raw talent, the passion to win, the proven mental toughness to get through difficult situations, instinctual decision-making, and mentoring. What do you think?
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