Permanent Value

Week in Review – 01/16/2017

Bruce Doole
January 16th, 2017
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.

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.

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.

Source: Rick Kahler

THIS WEEK’S ECONOMIC DATA:

  • China Consumer Price Index rose 2.1% in December, down from the seven-month high of 2.3% recorded in November.
  • U.S. EIA Petroleum Status Report Crude oil inventories rose 4.1 million barrels in the January 6 week to 483.1 million, up 7.1% from last year at this time.
  • U.S. Jobless Claims remain very low, at 247,000 for initial claims in the January 7 week.
  • China Merchandise Trade Balance fell to $40.82 billion in December from $44.61 billion in November, somewhat below the consensus forecast.
  • U.S. Producer Price Index rose 0.3% in December.
  • U.S. Retail Sales posted a very solid gain in December, up 0.6%, but without autos the gain falls to only 0.2%

Source: Ivy Weekly