Jim'sMoneyBlog

Financial Opinion and Insights

Interest Rate Outlook

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

 

The credit market meltdown didn’t make many people happy, as many investors, depending on their allocations, saw significant declines in their investment portfolios.    The scenario was typical:  Running to stocks as they go up and selling out of them as they go down while flocking to the safety of government securities, which sent prices up while pushing yields down to historic levels, where they are still.  

Where’s the foreign money?    

Federal bailouts, home price collapses and high unemployment continue to cause great concern globally.  Central banks, hoping to spur lending, have eased monetary policies — to historic extremes in some cases;  But, if you’re a bank, do you want to put out risk capital at these rates? 

Investors may be faced with low interest rates for some time, causing challenges in generating the current income they seek.  

Money Fund Changes 

Recently the rules regarding eligible securities for money market fund portfolios have been tightened in order to reduce the risk that a fund’s net asset value (NAV) will fall below $1.00.   This limits the fund companies’ ability to buy longer maturities where returns are generally higher, which reduces their exposure to securities that proved to be hard to sell during 2008-09.  This basically reduces what’s available for investments in money market funds; therefore,  the return offered by money market funds is likely to be lower than it would otherwise be under the old rules in exchange for the continued use of a constant $1.00 NAV. 

When will rates rise?   

The market – and the pundits – seem to believe low rates will continue into 2011.   Just how fast the subsequent rise will be, if at all – especially for money market instruments (less than one year to maturity) where a majority of liquid assets are invested – is anyone’s guess.     When they do, it’s important to understand that the rise will be coming off historic lows!  

 If the Fed follows its tradition of slow,  deliberate increases, rates could remain at low levels for many months to come.   Movements toward what many investors consider to be the norm for short term interest rates (perhaps 3-4%) just might take a long time.  

Rates may be down; but uncertainty is UP! 

Uncertainty is relative, to be sure.  I do not recall an environment that was ever `certain’, although many people seemed certain their houses would go up in value forever at the same time `day-traders’ were sure they could beat the market with a system they bought at a seminar or off an infomercial. 

So far, the Federal Reserve and financial regulators seem to be pleased to see capital flow out of money market funds and into longer maturity, higher risk, investments. 

Unless the risk of higher inflation becomes elevated – or the FED sees a dangerous bubble occurring in other assets caused by the low Fed rate environment, I wouldn’t look for much change.   My guess is you won’t see much from the Fed until and unless they see an economy is demonstrating organic growth consistent with stable employment.  Stay tuned. 

Federal Reserve Chairman Ben Bernanke continues to advocate keeping interest rates low because of his concern about a “nascent recovery”, a weak housing market, high unemployment, and a frail lending environment.  In his most recent semi-annual testimony to Congress, he stated short-term interest rates, near zero, were likely to remain there for several months (The Wall Street Journal: February 25, 2010 pg. A2). 

Okay.  Zero interest.  Now what? 

The answer is simple:  It depends. 

Yield and liquidity represent conflicting demands, just as does growth and safety. 

You can’t have sufficient liquidity without giving up some yield, and you can’t get additional yield without giving up some liquidity.   You’d think this would be obvious, but  investors sometimes want to have their cake and eat it too!   No wonder we plan… 

The hidden boogie man – hyper-inflation. 

The U.S. is running up a lot of debt these days; and at some point all that debt will come due to all those bond holders, many of them foreign.  I don’t see how, under any tax structure, that revenue would be sufficient, given annual budget demands, to pay it all off.  The presses in Washington will have to start rolling.  When this happens, don’t be shocked if the dollar drops and prices rise significantly.  If you’re plan is in-place, you shouldn’t be.

Written by Jim Lorenzen, CFP®, AIF®

August 3, 2010 at 8:00 am