Each quarter, we share videos on investment topics to help you better understand how we manage portfolios. This quarter, we start with an update on recent portfolio allocation moves, then explore the forces driving interest rates and the distinct roles of the Federal Reserve and U.S. Bond Market.
A couple of small incremental allocation changes were approved recently. The exposure to growth stocks was trimmed in many portfolios during the tech sector run-up in June. More recently, the Investment Committee approved an increase in the allocation to energy stocks in the more conservative portfolio strategies, which will be done by reducing the allocation to growth stocks in those portfolios.
Recent events make this a good time to review the forces driving interest rates as the topic of our portfolio snapshot.
In mid-September, the Federal Reserve announced that it was raising its federal funds interest rate by a quarter of a percent for the first time in a couple of years. Given all the media coverage this gets, it would be easy to assume that the Federal Reserve has broad control over all interest rates. In reality, the Federal Reserve shares that power with the U.S. bond market, a $58 trillion behemoth that is arguably the backbone of the entire financial system.
A simple way of looking at the relationship between the Fed and the bond market is that the Fed has the most control over the short-term interest rates, while the bond market has more influence over interest rates longer than five years.
While the Fed would like to influence longer-term interest rates, its influence over short-term interest rates is greater, stemming from its control of the interest rate charged by the Fed Funds Program. That program facilitates one-day loans between banks. Despite being very short-term, the Federal Funds Interest Rate influences what financial institutions pay on customers by the Fed Funds Program. That program facilitates one-day loans between banks. Despite being very short-term, the federal fund’s interest rate influences what financial institutions pay on customer savings accounts, charge on lines of credit, and credit card rates, all of which will be adjusting to the Fed’s latest rate increase.
Longer-term interest rates are primarily influenced by the numerous traders and investors in the bond market whose actions reflect their expectations for inflation, economic growth, as well as the level of federal borrowing. That is why auctions for U.S. Treasury bonds are closely watched as well. As the largest global borrower, the interest rates the U.S. government needs to offer to sell its bonds, in turn, influences interest rates on mortgages, corporate bonds, and other debt instruments.
Case in point, you can see on this chart [02:40] how the 30-year mortgage rate closely tracks the ups and downs of the 10-year Treasury bond yield. With that yield now crossing above 5% for the first time since 2007, borrowing costs across the economy will be moving higher right along with it.
In reality, the behaviors of the Fed and the bond market influence each other. The Fed watches moves in bond yields to understand how investors are reacting to current economic trends. Bond market investors seeking to understand what the Fed is thinking look to the monthly meeting notes covering the Fed’s open market committee deliberations on whether to change the Federal Funds Interest Rate.
This give and take looks to be changing as new Fed Chairman Kevin Warsh has indicated he feels the high level of transparency in those meeting notes gives the bond market investors too much ability to adjust ahead of any Fed intervention, thereby blunting the Fed’s efforts to influence long-term interest rates. Bond market participants, though, wonder if the Fed being more tight-lipped will just lead to higher levels of bond market volatility.
Given recent bond market and interest rate moves, the Boulay portfolio team feels pretty good with how we’re positioning portfolios. The AI boom and lingering Iran war, while continuing to impact prices, is also benefiting our allocation to commodities. The Fed’s raising of its Fed Funds Interest Rate and the rise of the 10-year Treasury yield confirms our belief that short-term bonds are the optimal fixed income allocation, as they tend to perform better than longer-term bonds in a rising interest rate environment.
If you have questions about how interest rates impact your portfolio, reach out to your Boulay Wealth Advisor. If you are not a Boulay Wealth client but wish to learn more, check out the Wealth Management section on our website or contact us using the button below.
Investment Advisory Services offered through Boulay Financial Advisors, LLC a SEC Registered Investment Advisor.
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