Understanding Interest Rate Movements

Investors have been living with low interest rates from late 2008 through current times. Interest rates have been so low for so long that the recent upswing in rates caught many investors by surprise. From the beginning of the year through June 20, the 10-year Treasury rate went up by 0.67 percent from 1.75 percent to 2.42 percent. While this rate is still low from a historical perspective, this is nevertheless a large increase.

Why Have Rates Increased?

In most developed countries such as the U.S., interest rates are heavily influenced by central bank policy. The Federal Reserve is the U.S.’s central bank. For several years, the Federal Reserve has pursued very “loose” monetary policy, meaning it has done everything within its means to keep interest rates as low as possible to aid in the recovery of the U.S. economy. On June 19, Federal Reserve Chairman Ben Bernanke indicated that the central bank might begin curtailing its loose monetary policy later this year and ending some portions of its policy next year. These indications about future plans are no doubt one reason that interest rates have been increasing.

Will Rates Continue to Go Up?

Of course, we believe it is virtually impossible to guess the direction of future rate movements. We can, however, say something about what might cause rates to increase further or to fall. Some reasons why rates might further increase:

• The economy performs better than expected.
• The market’s expectation for future inflation increases.
• The Federal Reserve tightens monetary policy more quickly than expected.

Conversely, rates would likely fall if the economy unexpectedly performed poorly, inflation expectations declined or the Federal Reserve decided to pursue loose monetary policy.

How Have Bond Investments Been Affected?

When interest rates go up, bond prices go down. Therefore, returns on bond investments can be negative during these periods. In general, though, short- and intermediate-term bond investments have not been severely affected. For example, the Barclays Capital Intermediate-Term Government Bond Index is down just 1.09 percent through June 20. Further, the Barclays Capital 5-Year Municipal Bond Index was down just 1.19 percent over this period. While no one enjoys negative returns, these are hardly sharp negative returns.

Keeping the Big Picture in Mind

For investors who have followed our general guidance to use short- and intermediate-term, high-quality bonds and bond funds, there is a positive side to higher interest rates. Higher interest rates mean the bond returns you expect to earn are higher now than they were previously. For investors with a long investment time horizon, this is a plus.

Investors must also keep a total portfolio perspective in mind. While interest rates have increased and some bond investments have experienced negative returns in 2013, the stock market is up with the S&P 500 Index up 12.5 percent through June 20. Because one of the key concepts behind diversification is having investments that move in opposite directions, this yet again shows the benefits of having a well-devised approach to building diversified portfolios.

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