While playing the lottery is by definition a loser’s game, how many among us have never once imagined winning a huge prize? Quite apart from the material advantages, how nice it might be never to have to read another word about optimizing one’s investment portfolio. Stories about quantitative easing, the oversupply of Chinese housing and the deposit insurance system of Cyprus could be happily skipped forever. The winner might simply drop the prize check into a safe bank account from which monthly interest could be drawn. How hard could that be? Unfortunately, when we consider the relationship between the size of the lottery prize and the amount of spending it supports, we get a sense as to how far down interest rates have been pushed.

Let us imagine that our winner wants to leave his prize to his children and will thus live only on the interest it generates. He has calculated that he needs about $6,000 a month (after taxes) to meet his needs, and he already collects $2,000 from social security. Hoping to use a financial calculator for the last time in his life, he discovers to his dismay that he is not yet free to ignore the deliberations of the Governors of the Federal Reserve (whoever they are). Specifically, if half of his prize goes to taxes in the year he wins, if he then pays 25% of his subsequent interest income in taxes, and if his “high yield” savings account pays 0.12%/year in interest (as mine does today), then the $4,000 of after-tax yield he requires each month will require a lottery prize of almost $107 million.

Bank savings interest rates are all but set by the Fed through what is called, appropriately enough, the federal funds rate, which currently targets a rate of 0% to 0.25%. Rates this low are so unattractive that even the highly risk averse may feel pressured to take the next step up the ladder of risk and buy bonds. Those who buy bonds are loaning their money to others, and the cautious might prefer to loan money only to reliable governments, such as that of our United States, rather than to corporations that are quite capable of defaulting (rather than turning on a printing press) should they run out of money. Long-term loans are subject to high interest rate risks, so our lottery winner might wish to limit the length of his loan to 5 years. A 5-year U.S. Treasury bond currently yields about 1.4%. While this yield is a bit better than the interest rate on bank savings accounts, our lottery winner must still hit the jackpot and win at least $10 million to generate $4,000 of monthly, after-tax income.

It is that challenging an environment for those who want to play it safe, such as many retirees. Even a modest amount of income is extremely difficult to generate. Going to trusted states overseas is no help (the 5-year government bond issued in Germany currently yields 0.15%), and so it becomes necessary to mix in some riskier assets and perhaps hope that interest rates will soon rise.

Careful What You Wish For
While yield starved retirees have elicited a surprisingly small amount of sympathy in the financial media, most observers nonetheless express a clear preference for the rise in interest rates that will result if and when the Fed slowly increases the Federal funds rate and also refrains from expanding its balance sheet, which it has done via the purchase of trillions of dollars (yes, trillions with a “t”) of Treasury bonds and agency paper. Higher interest rates might be beneficial to conservative savers, but the outstanding question is whether the U.S. economy can withstand the slowing effect of those higher interest rates without slipping back into a recession. After all, even with unprecedented Fed intervention, it’s not as if today’s economy is booming. This leads many to recommend that the Fed delay the unwinding of its current policies until it seems safer to do so.

Federal Reserve Assets Chart

How the stock market might react to a world without the aggressively stabilizing role of the Fed was perhaps suggested in early October. Within the course of a single week the most common measure of U.S. stock market volatility, the VIX index, spiked to levels not seen since the 2012 eurozone crisis. While there were as ever a multitude of explanations proffered, including clear signs of yet another economic slowdown in Europe, it may not have been entirely coincidental that volatility rose suddenly in the same month in which the Fed was expected to end the bond buying program known as quantitative easing.

Federal Reserve Assets Chart

While nervous economists are quick to warn that an increase in interest rates will slow economic growth, the more optimistic suggest that a more normal interest rate environment may boost investor confidence and help insure that financial markets direct capital only to those parts of the economy in which it will be best utilized. In extended periods of very low interest rates, it is argued, money is poorly allocated and underlying economic weaknesses are merely masked, creating the conditions for the next crisis. Indeed, many believe that the interest rate cuts implemented after the implosion of the technology stock bubble merely created a subsequent bubble in residential real estate.

Many Flights are Bumpy
In conjunction with early October’s rising volatility, the U.S. stock market (as measured by the S&P 500 index) fell by almost 10%. At the worst point in an especially bad day for stocks, the S&P had given up virtually all of its gains for the entire year. While the volatility and the price swings abated as quickly as they had arisen, there seems little doubt that a scheduled return to interest rate normality will require that investors once again demonstrate the fortitude to endure a bumpy ride and the discipline to maintain a long-term focus.

Perhaps forgotten over the past several years of gentle stock market conditions is that short-term price swings don’t necessarily presage disaster but are in fact a normal part of the stock market. Owners of simple S&P 500 index funds, for example, have earned more than 11% per year since the beginning of 1980. In 26 of those 34 years, the U.S. stock market rose, so those who looked at their brokerage statements only on New Year’s Eve might be inclined to think that their investments had risen smoothly about three-quarters of the time. Within those 34 calendar years, however, more attentive investors would have seen intra-year drops that averaged more than 14% per year. As such, while the industry typically labels as a “correction” a decline in the stock market of more than 10%, even the extremely profitable strategy of buying a U.S. stock market index fund has required investors to endure not just volatility, but sizable losses within most years. The ability to stay focused on longer-term financial goals will likely be tested once again if the removal of interest rate stabilizers is not skillfully negotiated. Prolonged periods of low volatility are the exception, not the norm.

Filed under: Investing

Share:
back to all posts
SUBSCRIBE TO OUR NEWSLETTER

Get B|O|S Perspectives
in Your Inbox