How To De-Risk Your Investments Under Different Interest Rate Scenarios

At the end of February, we discussed whether investors with spare cash should invest or save.  However, beginning on March 8th, bank runs started to occur at Silvergate, SVB, Signature and depositors started to lack confidence in our US regional banking system. These bank failures have now complicated the Fed’s ongoing fight with inflation and adds more complexity for not only the Fed but also for us, investors.  For beginners investing in the market, in this blog post, we’ll review the recent bank failure events, outline three potential upcoming rate action scenarios by the Federal Reserve and share the approach we’re taking to de-risking our portfolio.  

First, let’s review the recent 3 bank failures and why there was a loss in trust that resulted in a liquidity crunch or bank run:  

• Silvergate Bank, a cryptocurrency-focused bank, announced it would unwind its operations due to significant losses it suffered in its loan portfolio as a result of the Fed’s rapid rate hikes making the bonds less valuable vs. their original cost (e.g., interest rate risk) and the need to sell these bonds before maturity in order to meet sudden depositor withdrawal requests because of the recent collapse of cryptocurrency exchanges (e.g., FTX, Genesis) 
• Silicon Valley Bank, the 16th largest US bank with significant client concentration in VC and tech companies, purchased long-term Treasury bonds in 2021 given the large influx of deposits it received from its clients due to IPOs and ease of access to capital. However, like Silvergate, they faced interest rate risk from the Fed in raising rates in response to inflation.  When clients started pulling their money out to meet liquidity needs, SVB was unable to meet the withdrawal requests based on the amount of cash on hand and declared the need for an emergency $1.7B capital raise, spooking investors and triggering the bank run
• Signature Bank, originally known as a commercial and multi-family real estate lender, began shifting its business towards cryptocurrency in 2018 becoming the second largest cryptocurrency bank after Silvergate.  They faced a bank run from depositors after recent cryptocurrency price declines, especially after the collapse of FTX as well as other cryptocurrency exchanges with the NYS Dept of Financial Services and the FDIC seizing the bank and placing it under receivership

To restore depositor faith in our banking system, the Federal Reserve, FDIC and US Treasury intervened and created an emergency backstop program called the Bank Term Funding Program (BTFP)

• The BTFP offers loans of up to 1 year in length to banks, savings associations, credit unions and other institutions pledging US Treasuries, agency debt and mortgage-backed securities and other qualifying assets as collateral. Rather than forcing the banks to sell assets and realize the losses, the Fed’s program would allow them to pledge the assets as collateral for loans, freeing them from the need to sell and thus, minimizing the need to absorb losses due to interest rate risk due to depositor withdrawals
• JP Morgan suggests that this incremental $2 Trillion in funding into the US banking system and would ease the current liquidity crunch

How does the Fed’s interest rate impact prices of various asset classes?

Before analyzing the various interest rate scenarios by the Fed, we need to discuss the importance of the Fed Funds rate. The Federal Reserve’s effective fed funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. This rate is set by the Federal Reserve and can have a significant impact on the prices of various investment asset classes. 

In general, the cost of borrowing goes up when the Fed raises interest rates, which might lead to less investment and less expenditure overall. As a result, prices for investment asset types like stocks and real estate may decline due to a decline in investor demand. Yet, as the Fed reduces interest rates, borrowing becomes more affordable, which might encourage the economy’s investment and expenditure. As a result, investment asset classes may become more in demand, which could raise the cost of such asset classes.

It’s crucial to keep in mind, though, that the relationship between the prices of different investment asset classes and the Fed’s effective fed funds rate is not always clear-cut. Other factors, such as market sentiment, economic statistics, and world events, can also have an impact on asset prices. For instance, using the effective Fed Funds rate as a proxy since 1954, we examined the historical average yearly returns each asset class. As shown in the table below, the correlation between the two variables is not exact and does not equal one.

Table: Average Annual Returns of Asset Classes by Fed Funds Rate Since 1954

Source: Historical Fed Funds Rates from MacroTrends, NYU Historical Asset Class Returns

Note: The highlighted green cells above represent the top 2 returns for the given range of Fed Funds rate

At first glance, the average annual total return of the S&P 500 including dividends seem to provide double-digit performance regardless of high or low fed funds rates. However, when we dive deeper into the data, we see that this double-digit performance at higher fed fund rates is largely attributed to investor sentiment for more speculative assets during the mid-to-late 1990s during the internet dot-com boom when the S&P 500 grew by 20-30% annually.  In fact, you could argue that we’ve already started to experience a similar correction as the dot-com crash in 2001 with the S&P 500 falling ~19% in 2022 and there could be more downside risk to come.  This suggests that we cannot expect that in a high interest rate environment that we should assume the S&P 500 to continue to yield similar results. In the current high interest rate environment, several companies (not just limited to the technology sector) are laying off workers in multiple waves, implementing cost-cutting efficiencies and cancelling projects that may have long time horizons and unclear return on investments. Executives from large cap S&P 500 companies are signaling that 2023 and likely 2024 will be bumpy.

With regards to gold, we see mixed returns during times of high interest rates, which is counterintuitive since gold is often considered an inflation hedge and when the Fed raises interest rates to combat inflation, we would expect the demand for gold to increase.  Gold is generally a non-yielding asset, meaning that it does not generate cash flows or interest payments for its holders. Therefore, during times of high interest rates, when investors can earn a higher return on their money by investing in interest-bearing assets like bonds or savings accounts, the demand for gold tends to decrease. We see that gold prices trended upward during years when the Fed interest rates were between 4 and 5%, but yielded poor returns during years when interest rates were 5-6%.  This was likely the case because it largely coincided with the dot-com years of the late 1990s and there was more cash invested towards equities and risk-taking. 

However, according to the US Bureau of Labor Statistics, between 2008 and 2012, the price of gold increased dramatically as is evidenced by the 101.1% surge in the Producer Price Index (PPI). Gold was heavily coveted during the time of the Great Recession as many investors turn to gold to protect their principal. In conclusion, the relationship between the Fed Funds rate and the price of gold can be complex and is influenced by a variety of factors, including economic conditions, interest rates, and geopolitical events. It is important to note that while gold can serve as a hedge against inflation and currency fluctuations, it is not immune to market fluctuations and can be influenced by a variety of factors beyond government monetary policy.

Fed Scenarios and Asset Class Implications

The Federal Reserve’s job just got MUCH harder as Jerome Powell & Co. now need to weigh the following strategic options of:

1. Continuing its fight against inflation by raising rates and tightening credit even further OR 
2. Preventing a banking crisis which poses systemic risk to our financial system OR
3. Threading the needle on interest rate actions to accomplish both #1 and #2 

The Fed has a few scenarios it needs to decide in the coming days, which may include the following: 

Scenario A: Pause rate hikes but maintain current rates for longer 

If the Fed pauses rate hikes and maintain current rates longer, then this may suggest that risky asset classes such as equities would continue to provide a poor risk-adjusted return given that the risk-free rate would continue to be in the 4-5% range.  Could there be a short-term bull rally because the market perceives that the overall terminal Fed Funds rate will be lower vs. its previous estimates?  Of course.  However, the inverse could also be true in that the market could also be nervous that the Fed’s unwillingness to take more rate hikes means that we have a bigger underlying problem with our banking system, especially given the recent events of Credit Suisse.  Depending on if you have a long time horizon (10+ years), financial advisors may suggest that this is a great time to get into equities given the decline in prices. But if you are looking more near-term, why would you dollar-cost average into equities, when weighing the volatility vs. knowing that you can continue to get 4-5% in cash risk-free? 

• In my opinion, cash, CDs, 3-month T Bills, high yield online savings would likely still be the better risk-adjusted return asset in the near-term.

Scenario B: Continue to raise rates to a lower terminal rate given future bank runs “contained”

In this scenario, the Fed would opt to continue to raise rates but may be more cautious in the magnitude of the rate hikes because they recognize they still need to manage inflation while simultaneously monitoring any further impact on other regional banking institutions.  Most financial professionals have suggested that the Fed may implement another 1-2 rate hikes by 25 bps / each and then elect for a wait and see approach depending on future CPI and PPI reports.  

• While the terminal rate may be lower than what was previously projected, risky assets such as equities may experience a temporary rally, but this could still look unattractive compared to assets with the risk-free return (e.g., cash)   

Scenario C: Begin modest rate cuts over next 12 months by 100 bps

If the Fed starts to gradually begin reducing the Fed Funds rate towards ~3.5% over the course of the next 12 months, we may begin to see a few things happen: 

• Yields from cash, CDs and high yield online savings accounts drop, in parallel with Fed rate cuts
• Cash may move from risk-free to more risky assets such as equities inclusive of innovation/growth stocks as well as dividend stocks

In this scenario, the Fed would be acknowledging that the recent banking failures would further constrain credit and therefore, dis-inflation would occur because credit becomes much tighter, resulting in less need for further rate hikes and potentially even starting to taper down rates.  

By the way, keep in mind that Fed has NOT provided guidance on their position and relying on futures betting of the Fed curbing rate hikes because of the recent banking crisis could be a risky bet!

Portfolio Allocation Considerations

Given more volatility and uncertainty ahead, and since no one can predict the future, our approach to our portfolio is not to chase investment returns but to manage risk. Regardless of the Fed’s potential scenarios above with the Fed Funds rate, we’re going to patiently wait on the sidelines and monitor the situation. In every scenario above, we’re getting paid to wait in cash with experts agreeing that cash looks like a safe haven, at least for 2023!  Our current portfolio is 60% cash, 20% domestic equities and 20% fixed income. As an FYI, we also own physical real estate that is cash-flowing with rental income.

Naysayers will argue that sitting on cash will erode in value due to inflation. However, our perspective is NOT to keep cash in the long-term, but to 1) ride-out the near-term volatility and 2) it’s better than losing even more money in all other asset classes.  Additionally, our cash is not just sitting in one of the big 4 systemically important banks that earn no interest!  As detailed in our prior post earlier this year, we’ve parked our cash in money market settlement funds earning interest as well as other low-risk investments and therefore, it’s cash flowing and at least earning a respectable yield.

Here are some additional market dynamics (not exhaustive) that could negatively impact near-term returns regardless of the Fed’s actions: 

• More turmoil from additional regional banks, international banks and issues from Credit Suisse 
• Large banks taking on more risk by buying “debt” of regional banks
• Weak corporate earnings for Q1 2023
• Risk of resurging inflation
• Debt ceiling
• Geo-political risk

Even if the Fed decides to start to cut rates, the rates will still be higher for some time allowing you to re-deploy cash in your portfolio if that’s your preference. Our view is that if you were to buy equities or fixed income bonds now, prices could continue to fall and you would lose money short-term (e.g., “catching a falling knife”).  Most beginner investors are led to believe to “buy the dip” and buy via dollar cost average because the stock market will eventually go up over the long term.  In our opinion, this is a risky assumption in times of high market volatility.  Instead, active monitoring and being more defensive is critical in the near-term.  Every one’s financial situation is different and therefore, our views above are meant to be our opinions of what the market is telling us in how to de-risk during times of volatility and not meant to be treated as financial advice.  Please consult your financial advisors and invest safe!

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