What Are the 3 Incredible Fed Reserve “Variables”?

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The Federal Reserve is being more transparent, trying to lead investors and the markets with better guidance on their potential actions.

They’ve now winded down their bond-buying program. Next in line is increasing the Fed interest rate. But what do they look at before they pull the trigger?

GDP, Unemployment and PCE Inflation

The brain trust looks at three different variables. Really its four but one is just two different, but very similar, inflation numbers. You can take a look at their latest projections in this PDF.

GDP is, of course, the biggie. If our economy is shrinking, slowing or growing that’s gonna make a huge difference to Fed behavior. Next year they predict a range of 2.1 to 3.2 percent growth. And we just got quarterly numbers saying GDP grew by 3.9 percent!

That’s good news and confirms the belief that they will raise rates in 2015. Fully fourteen, of seventeen, members think 2015 will be the right time to raise rates. Only two members think 2016 is the prime time. So its a good bet that next year we’ll see rates move up.

They also expect unemployment to drop to as low as 4.7% in 2017. Or as high as 5.8 percent, depending on which Fed member you believe. The lower number would be an even bigger improvement than we’ve already seen.

The inflation figure is based on Personal Consumption Expenditures, or PCE inflation. Here they project very moderate rates no higher than 2.4% and maybe as low as 1.5 percent. That’s very moderate and below the 3 percent historical average.

With inflation expectations low rates should move up pretty slowly. They don’t have to put on the brakes quickly to control runaway price increases.

What’s an investor to do? Make sure sure you have plenty of risk exposure, short-maturity bonds and alternative bonds that behave differently than traditional bonds. Also, make sure you’re long-term bond exposure is very light.

HOW TO GUARANTEE A LOSS: Buy 5-Year CDs

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With interest rates being low for over a decade, it’s tempting to buy long-term products that pay better interest. A lot of investors will look at 30-year Treasury bonds, 5-year CDs or even long-lock-up fixed annuities.

Most of those actions are just about the worst thing you can do with Fed rates being near zero. You’ve probably heard of the seesaw relationship between interest rates and bond prices. One’s up, the other’s down. And vice versa. If you buy a 30-year T-bond, or other long-term bond, at low rates then the chances are very big that you’ll lose principal value when rates move up. Bad timing and low or negative returns.

With the CD or fixed annuity options you probably won’t get hurt. You’re not going to lose principal but you will be locked into rates that likely won’t meet or beat inflation. That means you have a real loss due to a consistently weakening dollar (inflation). A guaranteed loss.

Specifically, if you buy a 5-year certificate, with the current average yield of 1.56 percent, then you’ve lost ground to the average 3% inflation we’ve experienced. And that’s just the government figure for inflation. We all know, when you include food and fuels, real inflation is commonly believed to be even higher. So an investor needs to earn even more to really keep up and grow. But it’s possible.

Also, the fixed annuity could lock you into fees that last 4-7 years or longer. Beware of the exit details.

What’s one solution to low interest rates? Buy “alternative” bonds that have minor impact from rising rates. There’s a lot of different types out there. Also, invest overseas, add more risk categories (like real estate) and seek out sustainable, high-yield investments. Visit my site, RetireIQ.com, and request an appointment. We’ll talk about the details.

 

STOP! Read This Before Buying Municipal Bonds…

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It’s been years (years!) that the muni-to-Treasury spread has been flip-flopped. Now that’s finally back to normal.

In a “normal” economy and interest rate environment, the 30-year municipal bond yield should be lower than the 30-year Treasury yield. It makes sense when you think about it: A tax-free yield should be lower than a taxable yield due to the tax advantage.

For many years the opposite was the case. What did that mean? That municipals were drastically undervalued compared to Treasury bonds. Investors were willing to get less income from a taxable investment because they were afraid of cities and states defaulting on their debt.

Are munis now over-valued? I don’t think so. They’re just making up lost ground. The above-mentioned yield spread needs to be much larger just to get back to normal. Then the spread needs to be even higher for munis to be overvalued.

And municipal bonds are 60%-owned by individual investors. This makes them less volatile than other bonds like Treasury bonds which have many international owners (like China and Japan) and institutional owners (like mutual funds and pensions) that can add to price volatility.

What’s the big point? Keep buying those munis. You get a big yield and even bigger yield when your tax bracket is factored into the return.

Of course, use them for a small portion of an intelligently allocated portfolio. You should have many other asset classes like US and international stock, real estate, short-term bonds, etc.