Rule of thumb on rising rates still works but not in vacuum

The Insider

Your Money

August 14, 2005|By BILL BARNHART

IF THE FEDERAL Reserve were any clearer, there would be a billboard posted in Times Square: "Interest rates will increase!"

After a year of boosting bank lending rates to pre-empt inflation, the Fed is not finished.

The rule of thumb for investors says higher rates mean lower prices for stocks and bonds.

When money costs more, it's harder for business profits to exceed the cost of money.

Fixed-income investments you hold become less valuable in competition with higher interest rates paid by newly issued fixed-income securities.

Twice before in recent years, the Fed moved interest rates steadily higher - in 1994 and for 10 months starting in June 1999.

Investment results in those periods are worth reviewing. But don't fight the last war.

Real estate stocks, whose prospects depend on mortgage rates, suffered in the Fed's two previous interest-rate tightening campaigns.

But the sector defied the experts in the last 12 months by extending its multiyear rally. Ditto for utility stocks.

Likewise, small-company stocks are supposed to suffer when interest rates climb. That's because small companies often depend on bank loans, whose rates are tied directly to Federal Reserve policies.

Small-company stocks struggled in 1994 but rallied in early 2000 and were even hotter in the last 12 months, despite higher interest rates.

The rule of thumb about rates still works, but not in a vacuum. Other factors apply:

Rate levels. The level of interest rates affects the impact of interest-rate changes.

When the Fed undertook its rate increases in 1994 its target rate was 3 percent. The move in 1999 began with rates at 4.75 percent. Last year the Fed began when the rate was just 1 percent.

Since early 1994 inflation, as measured by the Consumer Price Index, has averaged 2.5 percent and never moved higher than 3.8 percent.

In other words, the Fed's interest rate moves since June 2004 are less onerous.

The curve. Despite 10 straight increases in overnight bank loan rates, long-term interest rates have remained unchanged in the past 12 months.

The so-called yield curve from short to long rates flattened.

The robust jobs growth report for July, released Aug. 5, and the 10th Fed rate increase, announced four days later, barely moved long-term rates by the end of last week.

Transparency. The hallmark of the Federal Reserve under Chairman Alan Greenspan has been avoiding surprises. The effect of Fed interest-rate moves is muted when they are well-telegraphed.

The harmful effects of expected interest-rate increases can be hedged. Many companies hold hefty cash hordes, enabling them to avoid borrowing at higher rates.

With these nuances in mind, higher interest rates suggest no radical portfolio adjustments:

Use money-market mutual funds and short-term certificates of deposit at banks to capture rising rates.

Favor large-company growth stocks, such as technology stocks, that benefit from the economic expansion that has induced higher interest rates.

Play the yield curve. Avoid stocks that rely on short-term consumer loans. Pick stocks that benefit from long-term financing, such as industrial bonds and mortgages.

Bill Barnhart is a columnist at the Chicago Tribune, a Tribune Publishing newspaper.

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