Do We Ever Really Know What to Expect From Rising Interest Rates?

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.

Rick Kahler
Advisor
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Rick Kahler, MSFP, ChFC, CFP is a fee-only financial planner, speaker, educator, author, and columnist.  Rick is a pioneer in integrating financial planning and psycholog ... Click for full bio

Most Read IRIS Articles of the Week: April 24-28

Most Read IRIS Articles of the Week: April 24-28

Here’s a look at the Top 11 Most Viewed Articles of the Week on IRIS.xyz, April 24-28, 2017 


Click the headline to read the full article.  Enjoy!


1. Implementing a Robo Advisor Strategy


Robo advisors can complement—not threaten—any bank’s business model and improve customer engagement. Regardless of age, income, or gender, 75% of bank customers surveyed by KPMG said they would be likely or somewhat likely to consider a robo advice service from their bank. — Greg Vigrass

2. The Sweetspot of Sales


I’ve had some extremely interesting conversations the last few days. We’ve been discussing sales, sales management, leadership, motivation etc. I am very fortunate to have the opportunity to meet with these inspiring business leaders. One question keeps coming up: Why do you love sales so much? — Tove Zilliacus

3. New ETFs That Reinvent Fixed Income Investing—Without Reinventing the Wheel


We all know the drill: the Fed raises interest rates, and the bond market falls. That’s an important equation to consider now that the decade-long era of historically low interest rates is slowly but surely coming to an end. — Salvatore Bruno

4. Alternative Beta Strategies: Alpha/Beta Separation Comes to Hedge Funds


A quiet revolution is taking place in the alternatives world. The idea of alpha/beta separation has finally made its way from traditional to alternative investing. This development brings with it a more transparent, liquid and cost-effective approach to accessing the “alternative beta” component of hedge fund return and a new means for benchmarking hedge fund managers. — Yazann Romahi

5. Advisors Will Be Extinct in 5 Years Unless…


I’ve had financial advisors for more than 40 years. Not once in those years have I called my advisor to find out what stock/funds I should buy or sell. But I have called to find out where I should get my first mortgage, when to sell my house, or how much income I could get in retirement. — Paulette Filion and Judy Paradi

6. Outsourcing Investment Management: TPAM vs. TAMP


Many financial advisory firms want the silver bullet solution to outsourcing investment management so the focus can be on client interactions and business development. However the jargon in this outsourced space has become very confusing so here is a brief summary of our understanding. — Jennifer Goldman​​​​​​​

7. How Can Financial Planners Save You From America's #1 Killer?


You probably aren’t aware of this, but it’s true: financial planners are heroes. Yep, it's the truth. And when you think of the America's top killer, you might think about smoking, cancer or obesity. Or maybe even a serial killer. — Ronald Sier

8. How to Stay On Clients' Minds


How to effectively stay on your clients’ minds (for all the right reasons), even though they may not see you for months. — Paul Kingsman

9. 20 Reasons Why Your Company Should Do Less Better


Do Less Better practitioners are fanatical about focus and de-complexity; herein lies the secret of their success. Yet, do less better isn’t something most leaders embrace. The seemingly more attractive (and logical) option is to do more and more — John Bell

10. Advisors: Where Should You Start with Content Marketing?


Often advisors ask us, “How should I get started in marketing?” It’s a fair question. They just want to make sure they’re putting their time and resources in the right place. — Jud Mackrill​​​​​​​

11. The 11 Best Steakhouses in the World


Serious carnivores will go to the ends of the earth to seek out a perfectly marbled, expertly seared steak. And so, it seems, will we. We've visited the best butchers in France, reacquainted ourselves with the idea that everything (steaks included) is bigger in Texas, eaten at celebrated parrillas of Argentina, and enjoyed the elegant ambiance of metropolitan steakhouses. — Andrew Harper

Douglas Heikkinen
Perspective
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IRIS Founder and Producer of Perspective—a personal look at the industry, and notables who share what they’ve learned, regretted, won, lost and what continues to ... Click for full bio