All Eyes On The Fed

Interest rates have replaced oil prices as the equity markets’ barometer du jour. The Fed recently boosted its target rate to 4.75%, up dramatically from 2.5% only a year ago. Monetary policy, which a year ago was “accommodative,” works with a lag. Today’s economy, based on 2.5% short-term rates, is lumbering forward – but not without concerns on the consumer side. The market seems to be taking at least one more rate hike – to 5% - for granted. A more important question to be answered, and we won’t know for a year, is whether (in fact) 4.75% was actually “too much” already.

If the Fed keeps marching onward and upward into oblivion, it will probably create…oblivion!

In the meantime, several other economic events are also squeezing consumers. By law, credit card companies are now required to amortize consumer debt faster, boosting monthly required payments for high balance borrowers. Higher energy prices reduce consumer discretionary spending, and falling real estate prices reduce homeowners’ ability to borrow against home ownership gains to fund ever expanding consumer tastes. Gone are the days when consumers could refinance their home equity loan to pay off their credit card in order to re-load the card (to get more free airline miles) and keep on spending. Where the Fed gets the courage to keep raising rates in the face of these headwinds, we don’t know.

Rising rates force bond prices lower. Bonds, though they are in our investment universe, are not in the portfolio – they dominate the worst performing sector list at the moment. As their prices decline, however, their income yields increase, which boosts their total return potential. If bond prices keep moving lower, getting more attractively priced, then it sets us up well for the future. At the point where the stock market finally loses momentum, bonds will be a more attractive alternative because of what’s happening to them today.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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