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The Lowdown on Low Interest Rates

While policy pronouncements from the nation's central bank always draw intense interest on Wall Street, the Federal Reserve's August update was especially noteworthy.

Specifically, the Fed said it planned to keep America's short-term rates near zero — not just for the next several months, but through at least mid-2013. That's an unusually long projection of the Fed's intent, so we turned to two USAA portfolio managers to understand what it means to investors.

A Gradual Recovery Grinds On

In light of the Fed's dual mission of maximizing employment while keeping prices stable, the Fed's far-reaching commitment to ultra-low rates signals the Fed's belief of two things:

The economy is still fighting for air.

"With consumer spending muted, the housing market still depressed, manufacturing slowing down and unemployment stubbornly hovering above 9%, the Fed has lowered its expectations for the pace of economic recovery," says John Toohey, vice president of Equity Investments at USAA. By keeping interest rates low, the Fed seeks to boost economic activity by encouraging lending and decreasing corporate and individual borrowing costs.

Inflation isn't a near-term risk.

"Loose monetary policies are always accompanied by some risk of inflation," says Toohey. "By signaling an intent to extend its near-zero interest rate policy for almost two more years, the Fed is also saying it sees little risk of steadily rising prices over that horizon."

While the Fed's attention-getting announcement focused on short-term rates, the central bank has also been pursuing tactics that attempt to push longer-term rates down as well, most notably the recently concluded "quantitative easing 2," or QE2. That, along with weaker economic data and flights to quality from nervous investors around the globe, has helped push 10-year Treasury bond rates lower, too. Indeed, the yield on that benchmark security fell to just 1.89% on Sept. 9, its lowest ever.

A Double-Edged Sword

Depending on your perspective, this era of sustained low interest rates can either be a blessing or a curse. Of course, it can be beneficial to corporations and individuals who are taking on new debt or refinancing what they already owe. However, to those with money in conservative choices, it may translate into returns that are a small fraction of what was available just a few years ago.

"By keeping interest rates this low, the Fed may also be trying to nudge investors out of 'safe' accounts and into longer-term or riskier securities," says Didi Weinblatt, vice president of Mutual Fund Portfolios. "However, investors shouldn't let the search for higher returns lead them to take more risk than they are comfortable with."

Bond Market Implications

According to Weinblatt, today's low-rate environment also affects the risk profile of bond investments in two important ways:

Price risk.

"Bond prices move in the opposite direction of yields," says Weinblatt. "If and when rates head higher, investors in long-term bonds could see the market value of their bonds decline."

Inflation exposure.

"At a 2% or 3% yield, it doesn't take much inflation to erase the after-inflation return on your money," says Weinblatt.

Stock Outlook Uncertain

While the economy remains sluggish, Toohey says, many corporate balance sheets are much stronger than they were before the financial crisis erupted in 2008. In addition to cost-cutting efforts, much of that improvement can be attributed to the lower borrowing costs created by the Fed's low interest rate policy.

"That's a positive for corporations, but over time, sustainable bottom-line growth — and stock price appreciation — needs to be supported by increased investment, consumer demand, fuller employment and greater economic output," says Toohey.

And while it appears that inflation may not be a short-term Fed worry, it's something investors may be wary of over the intermediate to long-term horizon. "The Fed's easy money policy has essentially saturated the economy in such a way that a pickup in credit growth and economic activity could create an inflationary deluge," says Toohey. "The question is: Can the Fed reverse course in time?"

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Contributor

USAA, a diversified financial services organization, is the leading provider of competitively priced financial planning, insurance, investments, and banking products to members of the U.S. military and their eligible families. Rated among the highest among financial services companies for customer advocacy in a Forrester Research survey, USAA provides convenient and accessible financial products to its more than 9 million members. For more information about USAA, or to learn more about membership, visit usaa.com
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