Originally published in MarketWatch.com http://www.marketwatch.com/story/fed-policy-and-your-retirement-portfolio-2014-08-07
At the most recent Federal Open Market Committee meeting, Chairwoman Janet Yellen reiterated that the economy is improving and deflation risks are disappearing. The Fed is planning on ending its QE, or quantitative easing, program in October and hasn’t signaled that it will begin raising rates before next summer in 2015.
In her semiannual Humphrey-Hawkins testimony to congress, Yellen mentioned that she thought that high-yield or junk bonds appear to be overvalued at current price levels. She also commented that,” a high degree of monetary policy remains appropriate” and she is especially focused on the labor markets. The Fed’s mandate is to control inflation and foster full employment.
Retirees with fixed income in their portfolios should be aware of how their investments could react to a rising interest-rate environment. The prices of long-term bonds with a high duration can be very sensitive to changing interest rates. The duration is a complex mathematical formula that factors in present value, yield, coupon, final maturity and call features of your bond. If you own individual bonds you can always hold them until maturity, if you’re invested in a bond fund you don’t have that option. The default rate for junk bonds can be high in recessions and the extra yield you’re getting right now from them may not be worth the additional risk. The yield on junk bonds is at historically low levels.
The BIS, Bank of International Settlements based in Basel, Switzerland published a report stating that the world’s central banks should be cautious about not falling into the trap of raising rates too slowly and too late. Both the Fed and the ECB brushed off the BIS warning and repeated that they are committed to accommodative monetary policies for the foreseeable future. The ECB is planning to start its own form of QE.
Yellen is focused on the labor market and wage growth which is a lagging indicator. By several measures our labor market is showing strength. For five months in a row we’ve seen over 200,000 jobs created and this hasn’t happened since 1997. The unemployment rate has dropped to 6.1% and unfilled jobs stand at 4.64 million which is almost a record.
Lately we’ve also seen increased foreign holdings of U.S. Treasury debt. Foreign nations are keeping the value of their currencies low to make their exports more competitive. They print more money, exchange it for U.S. dollars and lower the value of their currencies. Then they use the purchased dollars to buy U.S. Treasury debt, which acts like a form of quantitative easing, but the bonds purchased aren’t under Fed control. In the last Treasury auction the world’s major banks accounted for 52% of the sale which is about 10% above normal and the most since February 2006.
The BRICS have made an announcement that they will be forming their own central bank which could be a rival to the World Bank and the International Monetary Fund. BRICS stands for Brazil, Russia, India, China and South Africa. Forming their own bank could have an impact on global monetary policy.
Investors concerned about the effects of inflation and rising interest rates on their lifestyles should review their portfolios to see how sensitive they might be to a raising interest rate environment. You should also consider how inflation could impact your purchasing power.
If you’re invested too conservatively you could lose purchasing power over time to the ravages of an inflationary environment. If the rate of return on your portfolio doesn’t exceed the inflation rate your dollar won’t go as far. No one knows for sure when the Fed will begin raising rates or if we’ll see runaway inflation, but it may be wise to understand how your lifestyle could be impacted by rising interest rates and inflation.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.