Last week the highly anticipated fed meeting left us once again without a clear direction. All of the talk and anticipation of every Fed meeting caused me to pause and reflect on the role of the Federal Reserve. In short, “The Fed” is the central bank of the United States. In 1913 Congress passed, and President Woodrow Wilson signed into law the Federal Reserve Act. The Fed is tasked with managing U.S. monetary policy, regulating bank holding companies and other member banks, and monitoring systemic risk. Historically, the Fed’s monetary policy has been governed by a dual mandate: first, to maintain stable prices, and second, to achieve full employment.*
The Fed typically uses changes in interest rates in order to achieve its’ dual mandate. During our economic challenges in the mid-2000, the Fed’s began to lower interest rates in order to help bolster and grow the economy. We have been living with zero interest rates now for over six and a half years, the longest in history. You will find very few individuals arguing with the initial ZIRP or zero-interest-rate-policy; but you will find many, including myself, concerned that ZIRP has outlived its’ purpose. The natural course of things is the fed typically makes temporary, short-term, tweaks in order to nudge the economy along to a more “normalized” environment. A minor disruption may occur, but the minor manipulation causes little long term implications. This time, I fear, these tweaks have lasted so long, the market has begun to price them in, causing investors to make planning and investment decisions on manipulated data. The unintended consequences of all of this is a distortion of risk: investors and their advisors take on more risk in order to reach their goals.
It’s called a reach for yield or a risk on environment. Any time interest rates are low, investors are unable to make a return on typically “safe” high quality investments, like money markets, short-term bonds, Government bonds, corporate bonds, etc. When investors suddenly go from earning 4-5% to earning 0% or negative, they look for other places to invest their money and essentially take “risk on”. Most often these “other places”, often high yielding stocks or ETFs and junk bonds, carry with them a higher levels of risk, and with that comes a lower quality investment vehicle, creating a bubble of overvalued equities.
When interest rates begin to rise and volatility begins to increase, the movement will be towards a risk off environment, where investors can potentially get a respectable return moving back into higher quality, less risky investments. So when investors move from one investment to the other what happens?
The bubble pops. Think of a tidal wave, a shift from one shore to the other.
So as an investor, what should you do?
Open your statements! Understand what you own. What types of holdings do you have? Are they stocks and bonds? Are they high quality stock with a solid dividend paying history? Are the bonds high quality (AAA-A rated)? Are the bonds short to intermediate term?
Do you own ETFs or Mutual Funds? Mutual funds and ETFs hold stocks and bonds inside of them. Understand what stocks and bonds are held inside your investments.
Finally, manage your risk; become familiar with the term Standard Deviation. The standard deviation is a number that helps you understand the risk associated with your particular fund or portfolio. It is a measure of the ups and downs of your portfolios performance. It is most useful when you compare your portfolio against its benchmarks standard deviation. The golden rule is to make sure you are taking the least amount of risk in order to achieve your intended results.
If you are unfamiliar with any of these concepts, now it a good time to learn.
(The Role of the U.S. Federal Reserve Authors: James McBride, Online Writer/Editor, Economics, and Mohammed Aly Sergie Updated: August 26, 2015)
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