Capital Markets

(No) News at 11:00 – Fed Raises Interest Rates

(No) News at 11:00 – Fed Raises Interest Rates
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3 min 18 sec

Yesterday, the Federal Reserve raised short-term interest rates in the U.S. by 25 basis points, or one-quarter of a percent. Fed Chair Janet Yellen said, “the simple message is that the economy is doing well.”

The Fed’s announcement was likely the most widely telegraphed and fully expected policy move in its history. The stock market responded with a mild bump after the announcement at 2:00 pm EDT, and the S&P 500 was up a little less than 1% for the day. So the announcement is news, but not really.

Overall, the Fed expects continued improvement in the health of the U.S. economy.  The Fed has now raised rates three times since the global financial crisis, for a total of 75 basis points, or three-quarters of one percent, after almost eight years of essentially zero short-term interest rates. Market participants have been expecting the Fed to raise rates each year since 2010, and these expectations have been foiled by the modest recovery, or more correctly, the Fed’s response to the modest recovery. The Fed has held interest rates low through its setting of the official fed funds rate and through substantial asset purchases known collectively as quantitative easing.

All of these details are common knowledge, and the market’s modest response to a fully expected policy announcement is a welcome change from the usual market overreaction to meeting expectations. Media outlets of all kinds have dutifully reported on the Fed action and examined the reasons for the decision: strong job market, modestly rising inflation, solid economic growth, and adherence to stated policy. So far, so good.

What comes next? The inevitable question asked of Callan and others in the institutional investment advice business: “So what are your large institutional investors going to do in response to the Fed’s action on Wednesday?”

In a word, nothing! The assumption that a large, long-term institutional investor would “respond,” or change strategy, in the face of a fully anticipated, widely announced 25 basis point interest rate increase is both naïve and absurd.

Institutional investors set policy with a horizon of 10 years and longer, not for next week or next month. Callan sets 10-year capital market expectations to help guide strategic investment policy, and these expectations include this (and future) Fed interest rate increases as part of the baseline forecast.

Rising interest rates hurt bond returns in the short term, as the value of the bonds must be marked down to reflect the new, higher market interest rates. However, this change is relatively modest, and the loss is short-lived.

The Bloomberg Barclays Aggregate Index, a common benchmark for institutional bond portfolios, currently has a duration that is close to six years. Duration is a measure of the sensitivity of a bond to changes in interest rates. A duration of six years suggests that a 1% rise in interest rates would generate a 6% loss in value. However, this loss happens once, and then the portfolio generates a higher yield going forward.  New bonds bought to replace maturing bonds in a portfolio would have this higher yield as well. A 25 basis point rise in interest rates along the entire yield curve would generate a 1.5% loss in the bond portfolio.

To place this move in context, the stock market moved almost 1% in one day on Wednesday, just in the emotional response to the Fed’s move. The stock market can easily lose 10%, 20%, or in the case of the global financial crisis, 50% of its value in less than a year. “Responding” by shifting from a small, certain loss in bonds to large range of uncertain outcomes in riskier assets like stocks can be ill-advised and short-sighted.

Long-term investors have a perspective that should keep them from reacting to short-term moves in monetary policy, especially those that are fully anticipated and baked into the expectations that drive their strategic investment plan. So the message back to the inevitable inquiry is: sorry, no story here! Fed raises rates and long-term investors do nothing. As they should.

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