Rising Short-Term Interest Rates Can Benefit Retirement Investors

Higher short-term rates translate into additional income for investors from their bond portfolios, and their fixed-income allocation should provide greater ballast for the more volatile equity component of their portfolios, says Joseph Davis, with Vanguard.

The U.S. Federal Open Market Committee meets this week, and according to Vanguard principal and chief economist Joseph Davis, policymakers are “all but certain” to raise short-term interest rates by another 25 basis points, to reach the 2% to 2.25% range.

“Recent economic data make it an easy call,” Davis explains. “GDP was running at more than 4% on an annualized, inflation-adjusted basis in the second quarter; the unemployment rate is at a 17-year low of 3.9%; and the Federal Reserve’s preferred inflation gauge, the core personal consumption expenditures index, finally is hovering near its 2% target.”

For the large number of younger investors who have entered the equity and fixed-income markets since the Great Recession of 2008 and 2009, this is the first time they have seen short-term rates reach this level. And it has been some time coming—as the Fed started raising rates from prolonged historical lows back in December 2015.

Even for those with a longer history of investing, Davis says it is important to be reminded of the fundamentals of how steadily rising interest rates tend to impact overall portfolio performance. As he lays out, a rate hike this week would put short-term rates about 75 basis points below where Vanguard see them topping out for the current economic cycle, at around 2.75% to 3%.

According to Davis, with some caveats, higher yields on cash and safety assets are good news for retirement savers.

“Since the Fed started raising rates in December 2015, investors have channeled just north of a net $60 billion into money market funds,” he observes. “That coincides with an increase in average yields from almost zero to roughly 1.90% for Treasury money market funds and to well over 2.00% for prime money market funds. Inflows may well accelerate as rates rise further.”

Davis notes that bond investors “might cringe at our outlook for rising rates but, in truth, the short-term pain experienced when rates rise is offset by higher future returns.” He also expects fixed-income assets to provide increased portfolio diversification benefits as interest rates continue to normalize.

On the equity market side, Davis points out that many investors believe that rising interest rates are a harbinger of poor stock returns, “and they have some solid reasons for thinking that.” Simply put, higher rates make bonds relatively more attractive versus stocks, and higher rates slow overall economic growth, which theoretically weighs on corporate profits and stock prices.

“Financially savvy investors might also note that higher interest rates lower the value of future corporate earnings, thereby reducing their present value,” Davis points out. “The historical research we’ve done, however, doesn’t show a pattern of falling stock prices during rate-hiking cycles. In fact, hiking regimes often take place when the economy is performing strongly and earnings growth is robust, and therefore stocks tend to perform respectably during those periods.”

Davis points to the fact that, in the 11 periods of rising rates his team looked at over the past 50 years, stock market returns were positive in all but one of them. And even including the negative 15% return for the period of February to July 1974, the return of stocks across those periods was in line with the 10% average for stocks from 1925 through 2017.

Davis says the bottom line is that the global interest rate environment “doesn’t necessarily argue for a tactical tilt toward bonds or stocks.”

“And at any rate, tilting would amount to trying to time the markets, which research has shown time and again is a strategy that often doesn’t work out well,” he concludes. “One upside to staying the course is that higher short-term rates translate into additional income for investors from their bond portfolios. Another is that their fixed-income allocation should provide greater ballast for the more volatile equity component of their portfolios.”