Don't Fight the Fed
Friday, October 05, 2018
Don’t Fight the Fed
You may have heard the old investing mantra, "Don't fight the Fed." But what does it mean? Is this generally good advice for all investors?
When the Fed starts to raise rates, it does so to prevent the economy from overheating, which could then fuel higher rates of inflation. Rising rates also coincides with the late phase of the business cycle which immediately precedes a bear market and recession of a growth cycle (and hence closer to a bear market and recession). Therefore, a bull market for stocks typically peaks before the economy peaks. This is because the stock market is a forward-looking mechanism or "discounting mechanism."
To summarize, you would be "fighting the Fed," so to speak, if you remained fully invested when the Federal Reserve is raising interest rates or if you are conservatively invested when they are lowering rates or keeping them low. But the idea is NOT to fight the Fed! Therefore stick with stocks when the Fed is lowering rates and shift away from them when rates begin rising again.
Source and for more information:
A look at US Treasury Yields
Here is the 2-year US Treasury yield daily chart – Redline shows the long-term trend – no doubt where the trend is in yields – UP – the Federal Reserve Board has been raising rates on the short-end of the yield curve. Yield now stands at 2.87%.
30-Year US Treasury Yields
The 30-Year US Treasury yield daily chart below shows that resistance has been about 3.25%. That is, 30-year yields have been bonking their head on the 3.25% level, but as you can see, just recently broke out above that 3.25% level. We believe that may be significant. Yields closed yesterday at 3.386%.
The typical spread between the 2-year and the 30-year has been about 180 basis points (1.80%). Right now the yield curve is flat - that spread is only 0.52% (3.39 – 2.87).
In this rising rate cycle, we may expect to see the spread between the 2 year and 30 year yields normalize to 180 basis points, settling into a 30 year yield close to 5%.
We have already taken the following action in all of our model portfolios earlier this year in the face of rising interest rates:
Shortened the duration of our bonds, to reduce drawdowns and duration risk without sacrificing much yield
Invested in investment grade floating rate notes, where coupons adjust to movements in LIBOR, which may benefit from rising short-term rates and mitigate duration-induced price declines
We currently remain bullish on stocks.
Rising interest rates – generally is a good thing for stocks, it shows that investors are more confident about economic growth.
However, if rates rise too high, that has an effect of slowing down the economy.
At the current low interest rate levels, we consider rising rates good news for stocks, BUT, we will continue to monitor the situation.
Rapid increases in interest rates have given stocks a cold this week – we don’t want that turning into pneumonia.