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What the Fed's (in)action may mean for investors

June 20, 2013

More of the same—at least for a little while.

That was the message from Federal Reserve Chairman Ben Bernanke on June 19, as the nation's central bank decided to continue its aggressive efforts to stimulate the economy. The Fed will keep its interest rate targets at historically low levels, Mr. Bernanke said, and will maintain its $85-billion-a-month asset purchase program. However, he added, the Fed will likely begin scaling back those efforts sometime in the next several months, provided economic trends—particularly unemployment and inflation—keep pointing in the right direction. That part of the Fed statement, though widely anticipated, rattled financial markets in the United States and around the world.

Update: July 12, 2013

Expecting a Fed rate hike? Be prepared to wait

There seems to be a solid consensus that the Federal Reserve will maintain its target for short-term interest rates at extremely low levels for the foreseeable future.

Learn more »

We checked in with three Vanguard experts on the thinking behind the Fed's decision and what it might mean for investors.

What's your response to the Fed's latest policy statement?

Joe Davis, Vanguard chief economist: Broadly speaking, it's good news. The Federal Reserve feels that the U.S. economy is basically on the right track, and, as Chairman Bernanke reaffirmed yesterday, they will be able to begin tapering off their quantitative easing program in the fairly near future. For the financial markets and the economy at large, there is less perceived downside risk than there was a year or two ago. Looking forward, the Fed feels that the economy will no longer need the substantial support that it has provided by keeping interest rates low and expanding its balance sheet.

Joe DavisI'm not surprised by the volatility we've seen in the markets in the last few days. At Vanguard, we've had some concerns that the Federal Reserve's monetary policy might be "working too well" in the sense of encouraging investors to take on too much equity risk. Monetary policy is not a panacea; in some ways it's akin to psychological warfare, aimed at influencing investor behavior. At the margin, at least, the Fed's unconventional quantitative easing policy has worked in that regard, and the prospect of the policy being tapered off has unsettled some investors. Ultimately, though, a rising interest-rate environment would be reflective of a healthier U.S. economy, and that's emphatically good news.

What is Vanguard's outlook for the U.S. and other countries?

Joe Davis: Our view is that the U.S. economy will continue to expand at a modest pace, with real GDP growth in the neighborhood of 2% and inflation relatively contained. In the last few months we've seen improvement in the manufacturing sector and the housing market, but we're still seeing softness in other areas. Unemployment is still an area of concern, of course, although there has been progress there as well. It will probably be another year before the Federal Reserve feels that unemployment has come down to a level where it can then feel comfortable raising interest rates.

Looking globally, we've seen a significant slowdown in China. Europe is still in recession and shows no signs of recovering in the near term. Japan has yet to show the vigorous rebound we've been hoping for. The United States is the primary driver of global economic growth, and that's likely to remain the case for some time.

Will bond investors be hurt when the Fed begins to reverse course?

Ken Volpert, Vanguard Taxable Bond Group: It depends on how quickly interest rates rise. The futures market for 10-year U.S. Treasury bonds is anticipating rates will rise 0.4% over one year, 0.7% over two years, and 1.1% over three years; in other words, a slow climb.

Ken VolpertThe real yield on the 10-year Treasury is 0% now, up from –0.9% in late April. If rates go up 1.1% over three years, that would bring the real yield to 1.1%, compared with a more normal level of 2.0%. Such a gradual rise—which is the goal of the Fed's unwinding—will depress bond returns, but not into negative territory.

If rates rise faster than the market is predicting, bond returns could turn negative. Just as "financial repression" (in which monetary policy forces real yields—that is, actual yields minus inflation—into negative territory) has been bad for savers but supportive of economic growth, a return to more positive real rates could create a drag on bond returns in the short term but compensate investors with higher yields over longer periods of time.

Bonds can play a useful role in almost any portfolio, but many people find them confusing.

We've created interactive illustrations to take away some of the mystery:

Overview: How do bonds work? »

Duration »

Maturity and stability »

The yield curve »

Note: These illustrations require Macromedia Flash software and may not be viewable on all devices.

Fran Kinniry, Vanguard Investment Strategy Group: How markets react to the Fed's policy changes is driven largely by the reason for the changes and the degree of change, yet these factors are unknown. While much of the focus is on the bond market, the slowing or ending of the Fed's intervention could hurt equities and higher-risk investments more than lower-risk bonds.

Fran KinniryThe bottom line is that the details that emerge as to why there is a change in policy will determine the outcomes for various investments.

If investors are concerned about rising interest rates, where should they go for protection?

Fran Kinniry: Investors shouldn't confuse today's low level of rates with the future direction of rates. No doubt rates are low, so returns will be lower, but the future direction of rates is uncertain and not correlated with the current low rate levels.

Bond coverageThe interesting question is, protection from what? If investors are trying to make a call on the forward returns of stocks versus bonds, they are going to have to get a lot of things right. For example, how will each asset class move relative to the other? And by what degree?

There is also the matter of when these moves will begin and when they will end. Vanguard has consistently advocated the value of an all-weather, well-diversified portfolio in lieu of attempts to time the market, which have historically proved futile. Many have been calling for rising rates for a decade, so it's important to remember that reacting to headlines can be harmful to your portfolio.

What's the bottom line for investors?

Ken Volpert: The Fed's stimulative policies of recent years will be a headwind to growth going forward when the Fed will need to unwind its quantitative-easing buys by actively selling the bonds or by passively letting them mature.

It may take a long time for the yield curve to normalize to positive real yield levels, but that will be necessary to prevent excesses and asset bubbles that harm investors. The key is to use times when there is market volatility to rebalance your portfolio to your long-term stock/bond mix. This will lead you to sell the better-performing asset class and buy the weaker-performing one. The recent rally in stocks and selloff in the bond market may be providing a good rebalancing opportunity.

Ken Volpert on the bond landscape

Yields aren't what they used to be, for a number of reasons. In a brief video, Ken Volpert gives an overview of the financial and economic factors influencing yields and looks ahead to what's in store for bonds.

Watch the video »

Joe Davis: For investors, it may be helpful to set aside the question of when interest rates are going to rise, and by how much, and focus instead on your overall long-term investment strategy and your asset allocation. If you're looking for a certain rate of investment return, you have to understand that there's no free lunch. You have to be willing to accept a certain amount of risk—and there are risks associated with all types of investments—and be prepared for volatility along the way.

Fran Kinniry: I would suggest revisiting your situation from the fall of 2008 (when stocks were sinking) and the late winter of 2009 (when they were climbing). Rather than focusing myopically on the spring and summer of 2013, remember the emotions you felt in the good times and the bad. If you committed to an asset allocation appropriate for your time horizon and risk tolerance, your job now is to stay the course. The right allocation is having as much equity as possible but never so much that you aren't willing to stay committed to the allocation, including the discipline to rebalance in the worst of times.

 

Notes:

  • All investments involve some risk. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.
  • Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
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