Just because hikes aren’t imminent, doesn’t mean they’re not coming. Better to be prepared.
With all the talk about another round of quantitative easing by the Fed, it’s tempting to assume that interest rates will stay low for a long, long time. But that may be a costly assumption, particularly if you still have an adjustable rate mortgage, or are heavily invested in longer-term Treasuries.
Why worry about rising interest rates when Fed Chairman Ben Bernanke has signaled that he will do whatever it takes to keep the recovery going? The Fed has said explicitly that it’s likely to keep the federal funds rate, now close to zero, at “exceptionally low levels … for an extended period.” And if unemployment stays high and the economy keeps sputtering, the Fed has signaled that it will engage in another round of large-scale asset purchases, better known as quantitative easing, before long.
But what’s good for the economy in the short term could sow the seeds of trouble longer term. Remember, longer-term interest rates, which are set by the market (not the Fed), are partly a reflection of inflation expectations. And pumping a flood of money into the economy is likely to fuel those expectations, and push up long-term interest rates — and eventually short-term rates too.
Some experts already see this dynamic beginning to unfold. In a recent report, Morgan Stanley’s Chief U.S. Economist Richard Berner and Chief Fixed Income Economist David Greenlaw wrote: “Defying deflation fears and the consensus that inflation will decline, we think that inflation is bottoming, courtesy of shrinking economic slack and stable inflation expectations.”
Berner and Greenlaw argue that three forces will push inflation higher in 2011. First, they see slack in the economy diminishing and pricing power returning to the wholesale and consumer sectors. Second, they say strong global growth and a weakening dollar are beginning to push up import prices. Finally, they contend that by explicitly committing to take steps to spur growth the Fed is boosting inflation expectations.
If they’re right, we could see long-term and short-term rates rising faster than expected — and catching many off guard. If the Fed starts to see inflation returning, some Fed insiders are warning that we could see a replay of 1994, when the Fed shifted swiftly, and increased the fed funds rate by more than two percentage points in one year.
What can you do to shield your finances against that possibility? Here are six strategies to consider:
- Lock in a low fixed-rate mortgage. If you are still sitting on an adjustable-rate mortgage on a property you plan to live in for some time, don’t dally much longer. Mortgage rates fell to another all time low last week, with interest rates dipping to 4.45 percent on the average 30-year fixed-rate mortgage and 3.87 percent on the average 15-year mortgage. If you switch to a fixed-rate mortgage, you’ll pay more in the short term, but protect yourself against a possible spike in rates down the road.
- Buy some gold. Though the price of gold — $1,347 an once, as of Friday — is near an all time high, many experts believe it will go even higher as investors seek shelter from inflation and a falling dollar. Also, supply is limited, and there is growing demand for gold from central banks and emerging market consumers, particularly in India and China.
- Consider commodities. Global economic growth, led by emerging markets, means rising demand for commodities. What’s more, these assets are generally not well correlated with stocks and bonds. So, they are good diversifiers in an investment portfolio. And now you can buy them easily through exchange-traded funds (ETFs).
- Think about Treasury Inflation Protected Securities (TIPS). Because many people are still worried about deflation, TIPS, which are indexed to inflation, are currently well priced. By the time inflation is a clear and present danger, however, that probably won’t be the case.
- Build a bond ladder. If you buy bonds for income, rising rates could be a boon, unless you’ve locked yourself into low long-term rates, say by buying long-term Treasuries. If rates go up, the value of these bonds will go down, and relatively more than shorter-term, lower-quality securities. One smart strategy to consider is to build a bond ladder with a series of maturities, say from one to seven years. That way if rates rise, you can replace the maturing shorter-term bonds with higher yielding ones, and potentially boost you overall income.
- Think global. Emerging markets are growing much faster than the U.S. and many are running fiscal surpluses. Resource-rich developed countries like Canada, Australia and New Zealand are also on sound financial footing. And there are opportunities even in Europe where you can find world-class companies whose stocks have been unnecessarily beaten down by worries about the European debt problems. Add to that the likelihood of a declining dollar, and putting part of your investment portfolio in high quality foreign equities and debt could be smart move.
Of course, no one knows precisely when rates will rise. So you want to stay flexible. But buying a little insurance when it’s cheap makes sense. So, this period of historically low interest rates could be shorter lived that many are assuming. And if you haven’t seized the moment and considered refinancing into a low-rate long-term mortgage, you might want to take some time to do so now.
