By Dr. Jim Dahle, WCI Founder
Lots of people try to take advantage of what they think they know about interest rates (and particularly future interest rates) to boost their investment returns. This is particularly common in years like 2023 and well into 2024 when there was an inverted yield curve. Unfortunately, interest rate/bond/yield crystal balls tend to be just as cloudy as equity crystal balls.
Let me use an example provided by the well-respected Boglehead Nisiprius to illustrate.
How to Invest When the Fed Raises Interest Rates
When I originally wrote this in July 2023, the Fed had recently hit the pause button on its interest rate increases, but it also signaled that it expected to raise rates two more times in 2023. The unsophisticated, inexperienced investor hears that information and thinks:
“All right! Now I know what is going to happen with interest rates. So, I’m just going to sit in cash until the Fed gets done raising rates, and then I’m going to switch to long-term bonds and I’ll come out ahead of other investors!”
There are two problems with this sort of thinking. The first is forgetting that the Federal Reserve only effectively controls very short-term interest rates, like the Federal Funds Rate. This is the rate at which banks loan money to each other OVERNIGHT. Like for 16 hours. That’s a really short-term interest rate. But it correlates pretty well with the rates on cash and correlates a little bit with short-term bonds. It really doesn’t correlate well at all with intermediate-term and long-term bonds.
The second problem is that there are two crystal ball predictions you need to make. The first is what the Fed is actually going to do at its future meetings. The second is what the market will do in response. You’ve got to get both of them right to have any sort of advantage. Nisiprius calls both of these links “weak,” and now you’ve got a chain of two weak links. Don’t bet the farm on that.
More information here:
Restoring the Balance Between Savers and Borrowers
Why People Mistakenly Think the US Economy Is Terrible
How Does Fed Funds Rate Affect Investment?
To illustrate the point, Nisiprius goes back to the last time the Fed rapidly raised the Federal Funds Rate, as we were recovering from the dot.com crash. That Federal Funds Rate looked like this:
As you can see, the Fed increased the Federal Funds rate from 1% in mid-2004 to 5% by mid-2006. It was a pretty substantial increase. When interest rates go up, bonds lose value, and the longer the term on the bond, the more value it loses. Surely bonds, especially long bonds, got hammered between 2004 and 2006, right? Let’s check the tape.
You would expect cash to perform the best and long-term bonds to perform the worst, right? But what happened? The long bonds actually did the best, and cash did the worst. It turned out that short-term, intermediate-term, and long-term rates did not do the same thing as the Federal Funds rate. It was a good demonstration that the Fed does not necessarily control bond interest rates. In fact, the 10-year Treasury yield peaked at 4.81% in June 2004. That’s the same yield it had in August 2006. There was essentially no change, while the cash rates went up 4%.
The Modern Day
I wrote this piece in July 2023, but we didn’t get around to publishing it until October 2024. In September 2024, the Fed cut its “Federal Funds Rate” by 0.5%. What happened with cash, short-term bond, intermediate-term bond, and long-term bond rates?
The Vanguard Federal MMF yield fell from 5.28% to 5.09%, down about 21 basis points. Not exactly the 5o you might expect. That’ll take a little bit of time to work through.
One-year Treasury yields were 5.21% in May but began falling soon afterward. There was a fairly steep drop at the end of July and another in early September. It appears the market was anticipating the Fed interest rate movements. The yield bottomed out at 3.88% in late September, and it is now back to 4.24%. Who would have predicted any of that based just on statements from the Fed?
Seven-year Treasury yields were as high as 4.73% in April and fell in fits and stops down to a low of 3.52% on September 13. They are now back up to 4%.
Thirty-year Treasury yields have also been challenging to predict.
Like other bonds, they peaked in May and generally came down throughout the summer with a low near the time the Fed cut short term rates and then rebounded. The Fed cut rates 0.5% on one day, but long-term rates fell 0.75% over four months and then rose 0.37% in a couple of weeks.
Year to date, the MMF is up 4.14%, and a short-term bond fund is up 4.52%. Maybe you think you could have predicted all those changes, but I know I couldn’t have.
The Federal Funds Rate and Your Investments
It isn’t the things you don’t know that kill you. It’s the things you think you know that just aren’t so.
“Sure things” often do not come to pass. I learned a long time ago that my crystal ball is cloudy and cannot be relied on for investment purposes. I need a plan that is likely to be successful no matter what the future brings. That means I diversify. That means I stick with a fixed asset allocation, periodically rebalanced. That means I don’t try to invest according to my best guess of what interest rates or equity markets are going to do in the next few months or years. I just pretend I’m stupid (not that hard sometimes) and plow money into some stupid plan I put together 20 years ago and forget about it.
Guess what? Over time I generally outperform those who are always changing their investments according to their best guesses of the future—especially after the transaction costs, the taxes, and the value of their time. Join me and you’ll probably reach all your financial goals, too.
Need to get your own financial plan in place? Check out the Fire Your Financial Advisor course! It’s a step-by-step guide to creating your own path to financial freedom. Even better, we now have separate tracks for attendings, residents, and medical students. Try it risk-free today!
What do you think? Have you been caught trying to invest with a cloudy crystal ball? Do you pay attention to what the Fed does? Should you? Comment below!