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Lean Away from the Rate Rise

A couple of weeks ago Fed Chairperson Janet Yellen said she was “looking forward” to the prospect of raising interest rates this month, since that would indicate of an improving economy. I’d like to believe she was sincere in that sentiment, but I can’t help but wonder if she was using her bully pulpit to convince investors not to abandon the stock and bond markets when that day arrived.

We don’t have to wait any longer, as the Fed did in fact did raise its Fed Funds target rate by 0.25%, precisely in line with what it had been signaling recently. Combined with the dovish language that accompanied this event, the stock and bond markets showed no surprise, content that the Fed chose not to take weaker or stronger action at this time.

Yellen’s comment about “looking forward” to raising rates reminded me of the time my high school basketball coach tried to motivate us before a game against the reigning state champions by suggesting they had more to be worried about than we did. Sure, he said, they’re a lot taller than us, but we’re a lot smarter than they are (how he happened to know their collective I.Q. remains a mystery).

Unfortunately for my basketball team, it turns out being tall and skilled is more important than acing an algebra exam when it comes to putting a ball through a hoop, so we lost badly. Likewise, higher interest rates are generally regarded as an impediment to growth, not an advantage. But rising rates are here whether we like it or not, so having an investment strategy to deal with them has become necessary.

It has become trendy to use the faux-macho vernacular “lean in” when discussing any challenge that carries with it the potential for an undesirable result. However, the stock market has a nasty habit of punishing brash behavior, so in this case investors might be better served by proceeding cautiously rather than leaning in while financial markets adjust to what is most likely the first in a long string of rate hikes.

During Yellen’s comments immediately after the rate hike she made clear that the expectation is for additional rate hikes in the future until the fed funds rate gets closer to something commensurate with the expected growth in GDP, around 2 % to 3% annually. Since this month’s hike only puts us in the 0.25 – 0.50% range, there may be many more rate hikes to come. Do not be lulled into a false sense of security because this one didn’t do any damage; if anything, investors are advised to use this time to reevaluate their portfolios to determine what action may be needed before future rate hikes are priced into the market.

Although hedge fund managers and institutional investors have access to sophisticated financial products designed to offset rising rates that the average investor does not, several strategies are still available to individual investors that could mitigate the potential for damage. The specific strategy best suited to each investor depends on a number of factors including risk tolerance, time horizon, performance expectations and need for current income.

Of course, the simplest and most direct strategy is to decrease your exposure to financial assets that are likely to depreciate from rising interest rates, such as U.S. Treasury securities that pay a fixed rate of income. If you own individual bonds then you will receive full face value at maturity, but if you own a bond fund then there is no future point in time when you are assured of getting all your money back.

In that case you may want to consider a hedging strategy of owning other types of assets that are likely to appreciate when rates go up. Historically that has consisted primarily of “hard assets” such as real estate, precious metals and energy. Of those groups, only real estate has appreciated recently, so adding precious metals and energy holdings to your portfolio makes sense given current price levels.

A third strategy to consider is buying “inverse funds” that are designed to go up in value when the price of their associated benchmark goes down. For example, there are ETFs specifically designed to appreciate in value by the same degree that bond prices declines in value. However, due to the type of derivative financial instruments used inside of these , they are fairly accurate in the short run, but tend to underperform their benchmark in the long run so they are only a short term fix.

It also helps to know what not do during a potentially seismic event such as this. Namely, taking a contrarian stance by aggressively moving into the asset classes expected to get hurt by rising rates under the belief that a rate hike has already been factored into their prices. The fact is nobody knows the extent to which a subsequent bump in rates might trigger a wave of program trading that could temporarily exaggerate price movements in related securities.

If, for example, China decides to unload a big hunk of its U.S. Treasury securities to avoid bigger losses in the future, that action could temporarily push bond prices lower than expected. That in turn could cause a sell-off in highly levered securities such as REITs and MLPs. So, loading up on those types of assets for appreciation is a dangerous game to play and is best left to hedge funds and speculators.


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