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funds rate—and its impact on both the bond and stock markets. So, should investors like us really fear a rising fed funds rate? First, even a cursory glance at the chart on the left makes it readily apparent that changes to the fed funds rate in either direction are nothing new. It’s actually more unusual for the fed funds rate to be as stagnant as it has been the past five years. While there have been periods when the rate was moved higher and then lower and then higher in a fairly rapid series of actions, I’ve highlighted six periods starting in 1976, 1983, 1986, 1994, 1999 and 2004 when the general trend was tightening—or high- er fed funds rates. For those who like to ponder the numbers, in the table below, I’ve pro- vided the specifics of each rising rate cycle as well as several statistics on the economy at the time the Fed started to raise interest rates. A key takeaway is that no two rate cycles are the same. Each tightening cycle of higher rates started and ended at different levels and lasted varying lengths of time. In the 1976 cycle, the fed funds rate rose to more than four times its starting level, while the 1999 cycle saw it rise to just 1.4 times as high. The economic environments that motivated the Fed to raise interest rates were just as diverse, with inflation ranging from 1.7% to 6.3% and unemployment ranging from 4.2% to 10.2%. That’s the simple history. Now let’s get to the crux of the issue—the impact of rising rates on stocks and bonds. Bonds Stumble, Then Step Up Let’s start with bonds, as their per- formance is most closely tied to chang- es in interest rates. As we’ve seen over

RATES FROM PAGE 1 >

A Rising Fed Funds Rate is Nothing New

Rather than waiting for the event to happen and then reacting emotionally or getting caught up in the headlines, it helps to think through and prepare for those situations we can see com- ing down the road—even if the timing is uncertain. One way we can do this is by looking to history for potential lessons and as a guide for setting expectations. Before we get too far ahead of our- selves, let’s go back to square one and make sure we are all on the same page. The Federal Reserve, the U.S. cen- tral bank, is tasked with a dual mandate of trying to provide price stability and full employment. It is also the lender of last resort, as we saw during the financial crisis in 2008. Let’s be clear, though: The Fed does not control the economy or the markets. It does, how- ever, try to influence them, with often mixed results. The Fed’s primary tool of influence is the federal funds rate, or the inter- est rate at which banks lend money to each other overnight. How does that work? Well, banks take in and send out cash throughout the course of the day, but at the end of each day there is a minimum amount of cash they are required to have on hand. Some banks will be short of this mark, and others will have an excess of cash. A bank that is short will borrow the money from a bank that has a surplus. Typically, a bank only borrows the money for the night, because the next day, it may take in more money than it sends out, and would find itself in a position to lend any excess cash. This overnight rate is called the fed funds rate, and it is the base rate that banks then set other interest rates off of. It influences what banks are willing to pay on savings accounts and CDs, as well as what rate they are willing lend money at for, say, a mortgage or small business loan. Interest rates impact economic activity by motivating people to either save more or invest (spend) more. When interest rates are low, people are more likely to go out and borrow

10 12 14 16 18 20

Rising Rate Environment Prime Money Market SEC Yield Fed Funds Rate

0 2 4 6 8

6/78

6/82

6/86

6/90

6/94

6/98

6/02

6/06

6/10

6/14

money to buy a house or build a plant or start a company. But if you can earn a high rate of interest on a savings account, you might be more likely to keep your cash in the bank, earning that high level of income, and put off buying that house for another time. So when the Fed wants to encourage eco- nomic activity, it eases or lowers the fed funds rate. Conversely, if the Fed is looking to slow things down (or feels that it no longer needs to encourage more activity), it increases (tightens) the fed funds rate. The last time the Fed tightened was more than eight years ago in June 2006, when it bumped the fed funds rate up by 0.25% to 5.25%. Since then, it’s all been downhill. During the depths of the financial crisis, the Fed went to great lengths to keep the economy from a potential collapse, and brought the fed funds rate all the way down to 0.25%, which is, in essence, zero. As you can see in the chart above, the fed funds rate has been pinned there ever since. With the end of quantitative eas- ing in sight, investors are now looking ahead to the next step toward a more normal interest level—a hike in the fed

No Two Rate Hike Cycles Are the Same Start Date Fed Funds Starting Level Fed Funds Ending Level Change in Fed Funds Level Scale of Change # of Months

GDP Growth Inflation Unemployment

Dec-76 May-83 Dec-86 Feb-94 Jun-99 Jun-04 Current

4.75% 20.00% 15.25% 4.2x 8.50% 11.75% 3.25% 1.4x 5.88% 9.75% 3.88% 1.7x 3.00% 6.00% 3.00% 2.0x 4.75% 6.50% 1.75% 1.4x 1.00% 5.25% 4.25% 5.3x

40 16 27 13 12 25

4.3% 6.3%

7.8%

3.3% 4.1% 10.2%

2.9% 3.8% 3.4% 2.9% 4.8% 2.1% 4.2% 1.7%

6.9% 6.6% 4.2% 5.6% 6.1%

0.25% — — — — 1.5% 1.9%

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