Interest Rates and Your Investment Portfolio

The rate of interest is referred to as the “cost of money.” The Federal Reserve has flooded financial markets with liquidity, or cheap money for more than two decades.

Washington has effectively locked the federal funds rate at zero—in response to the ongoing COVID-19 pandemic. Intelligent investors recognize the effects of prevailing interest rates upon separate asset classes as part of the wealth creation process.

Federal Reserve Board

The 1913 Federal Reserve Act established the Federal Reserve System and awarded this institution with the contradictory dual mandate of price stability and full employment.

The Federal Reserve influences the interest rate environment largely through its open market operations, discount window, and reserve requirements, which are policy tools that directly affect the money supply. The Fed works to lower interest rates and expand the money supply amid recession – to encourage borrowing, spending, and investing.

Low interest rates, however, can very easily trigger rampant speculation and inflation. The Dow Jones Industrial average is now approaching a record 35,000 – with annual inflation running above 5% as measured by the consumer price index (CPI).

Bank Deposits

Savers now receive nothing on bank deposits. Taken further, interest rates on Certificates of Deposit (CDs), money market securities, and treasury bills are all but nil. For now, savers may consider maintaining cash reserves in short-term CDs and treasury bills that mature in less than one year.

Interest rates on these assets will closely track the federal funds rate and will quickly offer higher returns if The Fed were to drive rates higher.

Fixed Income Securities

Fixed income securities, such as bonds and preferred shares, pay out a level amount of investment income throughout their term. Pension plans, conservative savers, and seniors on fixed income are especially exposed to inflationary risks.

Stocks

Shares of stock represent ownership claims within publicly traded corporations. Low interest rates translate into reduced corporate borrowing costs and stronger discounted cash flow valuations.

Cheap money typically finances a stock market boom. The rich get richer, while the poor are then left holding a big grab bag of inflation.