Higher interest rates> are coming.
That was the unmistakable message from the Federal Reserve last week when it increased the discount rate, the rate it charges banks for borrowing reserves. Although the move came sooner than many expected, it was a healthy step toward more normal conditions and a sign the banking system is healing. The Fed stressed that the move doesn t mean any imminent rise in the more important federal funds rate.
Despite the soothing words, it s a clear warning that near-zero interest rates won t last forever, and that the Fed is prepared to act when necessary to raise rates.
In the abstract, this can t be a surprise. With short-term rates near zero, and even longer-term rates the lowest they ve been in my lifetime, interest rates really couldn t go much lower. But the question has always been one of timing. It s not clear exactly what the Fed means when it says it won t raise the federal funds rate for an extended time. Is that three months? Six? The Fed itself may not know for sure. But we now know it won t be an indefinite period. The tightening cycle has begun.
This has significant implications for investors, since markets anticipate events. Assuming we are in the very early stages of a credit tightening cycle, investors need a whole new strategy for a world of rising interest rates. Here are some of the implications investors need to address now and over the next several months:
Rock-bottom interest rates have had many worrying that high inflation will be the inevitable result. This has fueled a surge in prices for assets that are perceived to be hedges against inflation. The Fed s action last week has already dampened inflation expectations, and higher interest rates moving forward will add to the effect. Watch for a leveling off or decline in the prices of inflation hedges: gold, most of all; other commodities, especially metals; and Treasury Inflation-Protected Securities, or TIPS. (This week s auction of 30-year TIPS was perceived as weak, with higher yields than expected.) Investors should rebalance now, if they haven t already, and gradually reduce their commitment to inflation hedges over the next year. It s also time to rethink commodity positions. This doesn t mean long-term investors should abandon all inflation hedges. They still belong in every portfolio. But investors should no longer overweight them.
Higher interest rates typically ravage the value of fixed-income assets like bonds. Prices seem especially vulnerable now since so many investors have had no choice but to reach for yield in this exceptionally low rate environment. Long-term and lower-quality bonds will be the first to experience the effects. Investors should move to shorter-term maturities now (even though the longer maturities are offering higher yields) and reduce or eliminate exposure to junk bonds and other high-yielding bonds over the next three to six months.
Higher interest rates in the U.S. will mean a stronger dollar (it s already been rallying). That means non-dollar earnings from non-U.S. operations will have comparatively less value in dollar terms, as will a wide range of assets priced in dollars. As a result, investors current love affair with emerging markets will likely cool somewhat, although robust growth will help compensate. But after last year s big run-up in emerging markets equities, investors should rebalance now, lowering exposure to this asset class. Non-U.S. developed markets will likely suffer as well. And commodities priced in dollars (such as oil) may also be vulnerable. Investors should reallocate into high-quality U.S. growth stocks.
See Get Ready to Shop for Stocks And there s good news in higher rates, too: Money-fund rates, CD yields, and other low-risk fixed-income yields will eventually rise, boosting income for many investors.
For now, I m selling my position in the Market Vectors Russia exchange-traded fund, which I recommended last year. It fails three of my criteria for the rising-rate environment: It s an inflation hedge (dominated by natural-resource stocks); earnings are in a non-U.S. currency; and Russia is an emerging market. Best of all, it has more than doubled since I bought it. I ll put the proceeds in some of the U.S. stocks I ve recently recommended.
Given the Fed s measured pace, there s no rush to realign portfolios. But this is the time to start reformulating your strategy. Mark your calendars for three months from now, and make sure that by then you ve started implementing a higher-interest-rate approach.