Contributed by Lewis J. Walker, CFP®
Some years ago yours truly had the pleasure of speaking to a large audience of Japanese investment executives and financial advisors meeting in Yokohama, Japan. I had to submit the speech ahead of time to allow for simultaneous translation from English to Japanese. A form of “simultaneous translation” happens every year during the Federal Reserve Bank’s Jackson Hole, Wyoming summer retreat, held this year August 25-27. Roughly 100 Fed officials and economists attend closed-door discussions, to which only a select handful of reporters are invited. Others hang out in the lodge lobby overlooking the Teton mountain range, competing to pick up tidbits and scuttlebutt. That’s when the fun begins, coming up with clues as to Fed strategy.
Long running Federal Reserve Bank chairman Alan Greenspan, 1987-2006, was wary of financial markets overreacting to his remarks. He used what economist Alan Blinder termed “a turgid dialect of English,” employing ambiguous, vague, wordy, and lengthy statements to keep pundits guessing, dubbed “Fedspeak” or “Greenspeak.” Successors Ben Bernanke and Janet Yellen endeavored to tamp down complex obfuscation, with pronouncements now seen as Fedspeak 3.0. But the game continues, what one editor calls a “goat rodeo,” speculating on what the Fed really thinks and where we go from here.
Coming out of Jackson Hole, the Fed sees economic activity expanding. Household spending is strong and the labor market is improving. On the weaker side, business investment is soft; subdued foreign demand and a strong dollar restrain exports. Declines in import and energy prices are holding inflation below Fed targets of 2%. Fed gurus expect moderate GDP growth, added job expansion, and inflation rising to 2%. But note Fedspeak 3.0 per Chairwoman Yellen: “Of course, our decisions always depend on the degree to which incoming data continues to confirm the (Fed Open Market) Committee's outlook. And, as ever, the economic outlook is uncertain, so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy.”
The upshot? Interest rates are likely to rise, but Ms. Yellen is vague on timing or magnitude. Mr. Market seems to be betting that the Fed is unlikely to raise rates prior to the election, December the earliest we are likely to see a modest 25 basis point jump in the “federal funds rate.” The current Fed Funds target rate is 0.25%-0.50%; it could jump to 0.50%-0.75%. This is the interest rate applicable when one depository bank lends funds held at the Federal Reserve to another bank overnight, affecting monetary and financial conditions. It is scrutinized as a signal of Federal Reserve intentions, “easy money” versus “tight money,” with impacts on GDP growth, employment, and inflation.
What you should watch is the yield on 10-year Treasury paper. The fed funds rate is one of our central bank’s levers, whereas the 10-year Treasury rate is influenced largely by market demand for Treasury paper coming from bond buyers worldwide. The 10-year rate impacts mortgage rates and other key lending metrics. Whenever there is a flight to safety, buying pressure pushes bond prices up and yields down inversely. Negative interest rates and easy money policies by foreign central banks have increased demand for U.S. paper. If you look at the “Treasury yield curve” chart published in The Wall Street Journal, you will see that rates on Treasury paper with maturities from about two years out to thirty years are below where they were a year ago.
As of Friday, August 27, 2016, the 10-year rate was 1.63%; 30-year paper, 2.29%. The suspicion is that some bond observers are suffering from “recency bias,” looking at recent subdued numbers and expecting interest rates and inflation to stay well below long term averages for a very long time. We know that reality often overshoots expectations, and investors, especially those in or planning for retirement, should expect inflation ultimately in excess of 2%. Politicians always want to raise taxes, and planning for “real yields” in excess of inflation and taxation suggest gross investment returns in the 3.5% to 4% range just to stay even. If you want to spend 4% to 5% after inflation and taxation, average yields in the 7.5%-8% range are required.
How much risk you should take varies with your spending targets and spending habits, wants versus needs, your tax bracket, and the size of your portfolio. Betting that things will stay roughly as they are for many years seems unwise, as the bond market appears to be doing!
Lewis Walker is a financial planning and investment strategist at Capital Insight Group; 770-441-2603. Securities and advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative and investment adviser representative of SFA which is otherwise unaffiliated with Capital Insight Group. This information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. There is no guarantee that any opinion or suggested possibility will happen.