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How Changing Interest Rates Affect You

Posted by kdadmin on June 8th, 2015.

How Changing Interest Rates Affect You

Look at this graph of the market over the past two weeks. Which two of these four investments do you hope that you own? Which two do you think my clients own?

Two weeks ago, in my post, And We’re Out of Stocks, I talked about why I dumped the rest of my equity positions, moved to money market (CRM above), and took a small stake in AGG, an aggregate bond ETF. As you follow along below, you’ll be able to understand the investment theory behind this move.
For clarity’s sake, in the graph above, the lines represent the following:

  • SPY is an ETF that tracks the S&P 500.
  • AGG is an ETF that tracks the aggregate US bond market.
  • TLT is an ETF that tracks the 20 Year Treasury bond market.
  • CMR.TO is an ETF that tracks money market funds

This graph is an excellent example of how an increase (or a perceived increase) in interest rates will likely impact various investment types. Investment theory teaches us that:

  • Bonds go down when interest rates go up.
  • The longer the bond, the more it is affected by changes in interest rates. (TLT averages 20 years, whereas AGG averages 4 years.)
  • Equities (stocks) often go down when interest rates go up.
  • Stocks of highly leveraged firms (with lots of debt and interest to pay on that debt) are usually more affected by changes in rates.

So, if you look at the chart, you see that two weeks ago, when it looked like interest rates may stay low longer, TLT went up more than AGG. But last week, when it became apparent that rates would likely tick up sooner, TLT fell faster, and more, than AGG. Further, SPYrecovered a little when it looked like rates may stay low longer, but then SPYcratered when it became apparently that rates would likely tick up sooner. During all of this, CRM.TO, money market, stayed flat; essentially zero.

The scary party is that nothing actually happened to interest rates.

Imagine what is going to happen when the Feds DO change the rates. Imagine the volatility. Now imagine waiting out the storm in cash.

When I posted,And We’re Out of Stocks, two weeks ago, I took some flack. Some people said, “That’s an interesting move.” Others said, “That’s pretty aggressive.” Still others said, “Really?” In the investment world, this is known as People-Who-Don’t-Understand-Economics-But-Still-Want-To-Sound-Smart-By-Saying-Something-Snarky. This is the great thing about having a blog. All I had to do was refer them to how we were half in cash for all of last summer, avoided the high yield bond market wreckage (Ta Da! This Guy!), and managed to buy SPY at a lower price during the October correction than we could have bought it in May (Hunt the Black Swan).

Here’s the bottom line. IF both stocks and bonds are likely to go down when the Fed raises rates, AND both have been pushed to abnormal highs because of the impact of QE123, would you buy either of them if you didn’t have to? Me neither.

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