Bob French, CFA

How the Fed Impacts Your Investments

how the fed affects your investmentsThe financial media loves talking about changes in the target for the Federal Funds Rate. It’s the rate they’re talking about when they say the Fed is moving rates (as they’ve been saying this week).

It’s one of the easiest stories to tell in finance – there are people you can point to making a decision at a specific point in time that will (supposedly) have a specific effect. Everything falls in place nicely, and reporters can easily branch off and talk about the effects of the decision.

They can get tons of material out of the barest rumors around the Federal Funds Rate. But, as we know, what the financial media want to talk about and what actually matters don’t overlap much. The media is there to sell magazines and ads, not help you have a good investment experience.

So let’s take a look at how changes in the Federal Funds Rate actually impact your investments. The Federal Funds Rate is the rate at which banks loan money to each other overnight These are some of the safest loans out there, so there’s almost no risk of default. This means that the Federal Funds Rate is pretty close to the opportunity cost of letting someone else use your money – a risk free rate.

It’s no exaggeration to say the risk free rate is the foundation of finance.

Which Matters More: the Targeted or Effective Rate?

As important as the Federal Funds Rate is, it works in mysterious ways. What we want to know is if changes to the Federal Funds Rate actually tell us anything about what the financial markets are doing.

At the risk of spoiling the punch line, the answer is no – changes in the Federal Funds Rate don’t tell us much about movements in the financial markets. This is not to say the Federal Funds Rate isn’t incredibly important.

It is.

It describes the basic cost of capital for businesses, which can be used as an indicator of everything from business growth to employment levels to general economic activity.

As strange as it may seem, this information does not drive financial returns in the short term. Through constant incorporation of new information and subsequent adjustment of prices, the markets are built on expectations. The Federal Funds Rate is telegraphed well in advance by the Fed, so by the time it’s actually adjusted, the market has already reacted.

For this reason, we care more about the Effective Federal Funds Rate than the targeted rate. The targeted rate is the one all of the announcements are made about, but the effective rate is the one that actually prevails in the marketplace. They aren’t far off from each other (the Fed would have a huge problem if they were), but they aren’t exactly the same thing, either.

What Does the Federal Funds Rate Tell Us About the Markets?

We have good data on the changes in the Effective Federal Funds Rate from August 1954 on[1], so let’s start there. The best way to see if there is a relationship between two sets of returns is to look at their correlation; the movement of one variable in relation to another.

That will tell us how well changes in one series describe the changes in the other series, though as we have all heard a thousand times before, correlation does not imply causation. As a quick refresher, the closer to 1 or -1, the stronger the relationship between two series is. A correlation of 0 means there’s no relationship at all.

Looking at the numbers, there isn’t much of a relationship between the Effective Federal Funds Rate and the movements of the market. The observed correlations are negligible.

The correlation between the CRSP 1-10 Index[2] – an index that tracks the total US stock market and what we will use as our proxy for the US stock market – and the changes in the Effective Federal Funds Rate from August 1954 to August 2015 was -0.04. This means there was basically no relationship at all between the two series.

What if we look at bonds and the Effective Federal Funds Rate? There actually wasn’t a strong relationship there either. You can see the correlations below:

How the Fed Impacts Your InvestmentsJust like the stock market, the correlation between the Effective Federal Funds Rate and bonds is pretty weak.

We can also slice the time period down to see if more recent changes have different effects. You can see those results in the appendix, but the story doesn’t change – there is no meaningful relationship between changes in the Effective Federal Funds Rate and the financial markets.

For Every Action, There is an Equal And Opposite Reaction

But how does this affect you? What happens to your portfolio when the Effective Federal Funds Rate goes up (or down)? If you listen to the financial media, we’ll see another Great Recession if the Fed raises rates. Is this actually what would happen?

Let’s create three cases: the total time period, months when the Effective Federal Funds Rate went up, and months when it went down. Since we obviously don’t have equal time periods for all these groups, we’ll focus on the monthly average returns so we can compare the data.

How the Fed Impacts Your InvestmentsAs you can see, there is a marked difference between when the Effective Federal Funds Rate went up and when it went down. That being said, this is definitely not the “doom and gloom” scenario everyone talks about with rate hikes. While the average monthly returns decreased , they were still strongly positive. We don’t see anything like the disaster everyone predicts when a rate hike is expected.

What if we take this one step further? What happens when we have sustained periods of increases or decreases in the Effective Federal Funds Rate? Well, everything looks about the same.

How the Fed Impacts Your Investments

The average returns stay pretty consistent no matter how long the Fed is hiking or cutting rates. It’s only at the far ends where we see any big changes.

We probably see changes at the far end of the distributions because of the small sample sizes we’re working with are smaller. It’s tough to really make any projections from a handful of data points. The fact that the Fed so rarely moved consistently in one direction or another suggests these are cases we won’t see very often going forward.

It doesn’t matter if the Fed is making a one-time adjustment or is starting a campaign, the market reacts about the same. What this tells us is that the market takes these things in stride – sustained rate hikes aren’t the end of the world, and sustained rate cuts don’t mean we’re in for great market returns.

And yet this is all irrelevant until we can accurately predict what the Fed is going to do – or, more accurately, what the Effective Federal Funds Rate is going to do and when. The knowledge that an increase in the rate leads to lower (though still positive) stock returns doesn’t do much for us unless we know when those moves are coming. While there may be trends we can point to, it’s mostly random.

The markets don’t move in nice straight lines – they are jumping all over the place, with good jumps mixed in with the bad jumps.

Until we have a good way of predicting what’s going to happen in the future, we can’t time the market to avoid the bad stuff and get the good stuff. We need to focus on capturing the positive rates of return available to us in all market conditions. There’s no magic formula that will allow us to get the best returns during both cycles.

Main Street Versus Wall Street

All of this discussion so far has been about changes in the Federal Funds Rate. But since the Federal Funds Rate is fundamentally an interest rate on loans, the actual level is important.

We’ve been at near-zero levels recently, but we’ve also seen extremely high interest rates in the past. In July 1981, we actually got up to a 19.10% Effective Federal Funds Rate – keep in mind, these are some of the safest loans you can get.

For most people, and most businesses, rates like that mean they are conservatively going to be paying more than 20% interest rates per year. This has real consequences for the economy. So what do higher Effective Federal Funds Rates mean for investment returns?

Let’s look at the early 1980s. At this point, we had the highest Effective Federal Funds Rate, and it stayed high for a long time. We’ll look at the seven-year period from the beginning of 1979 to the end of 1985.

Over that period, the US stock market had an annualized return of 18.07%. If you were to invest $1,000 at the beginning of 1979, at the end of 1985 you would have $3,200. Not a bad seven-year period for stocks.

But since interest rates were so high, bonds did really well, too. How did stocks do relative to bonds? This is where it actually gets interesting.

One of the ways we look at risk in the stock market is by looking at how stocks did relative to bonds. From 1928 to 2014, on average stocks beat bonds by 8.15% per year. From 1979 to 1986, this spread was 8.32%. So, in essence, stocks were doing exactly what we would expect them to do versus bonds. They didn’t really react at all to the historically high Effective Federal Funds Rate.

Markets Move on New Information

When we step back, it makes sense that markets don’t move based on the level of the Federal Funds Rate. Markets move because of new information.

As soon as something happens – or someone starts worrying something is going to happen – that information is priced in. Prices move extremely quickly to reflect new information. Changes in the state of the world – or changes in perceptions of the state of the world – are what really move markets.

The Federal Funds Rate is just one of many things the markets use to price securities. It’s important, but it’s just one data point. The market is looking at thousands of other things, from what other central banks are doing, to earnings reports that are coming out, expectations for other earnings reports that aren’t out yet, all the way down to the weather report in Omaha.

The market is an incredibly powerful vacuum for information, and it condenses it down to a single number – a security’s price. That doesn’t mean it’s always right, just that we don’t know if the price is too high or too low.

The other reason is that there is a fundamental disconnect between real economy and the stock market, at least in the short term. In the long term, if the economy does well, the stock market will do well.

But in the short term, the stock market is about expectations. There’s a constant stream of new information, and much of it is contradictory.

The market is taking in this new information, and generating new expectations, everything that happens is measured against what the market expected to happen. It’s entirely possible for a company to report record profits yet have their stock price fall if they fell short of market’s expectations.

It’s the same thing with the Effective Federal Funds Rate. The Fed is watched incredibly closely, and they also want to make sure people generally know what they are going to do (at least in broad terms) before they do it.

This means the Fed doesn’t really do surprises. By the time you hear about a potential rate hike, that possibility is already priced in.

So What Does This Mean?

The point here is that you don’t need to worry about how the Fed will impact your portfolio – focus on building the best long term portfolio you can. Even though market returns tend to be lower when the Fed cuts the Federal Funds Rate and higher when they raise it, there’s no way to effectively trade on this.

While we generally have a pretty good idea what the Fed is going to do, we don’t know when they will make adjustments. And even when they do, it’s not a linear relationship.

There are periods when the market goes up after a rate hike, and down after a rate cut. The market reacts to expectations, so unless you are smarter than the market, this is not a game you can win.

There is no magic to investing. A lot of people have “get rich quick” schemes, but none of them work in the long run – you need to focus on the things that will actually get you to your financial goals.

You need to make sure you take the right amount of risk, build a diversified portfolio, and stick to your plan. If you can do that, you’ll probably be in pretty good shape for your financial future, regardless of what the Fed does.

Appendix

How the Fed Impacts Your Investments[1] Effective Federal Funds Rate data provided by the Board of Governors of the Federal Reserve System (US) and retrieved from FRED. The raw effective rate is provided from July 1954, and the monthly percent change was manually computed for this analysis.

[2] All returns data, except for the Federal Funds RateEffective Federal Funds Rate, provided by Dimensional Fund Advisors.

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