Among the tasks that central banks perform are: to control a nation’s inflation, regulate monetary policy, provide price stability and prevent the country’s banking system from failing. Bloomberg reports that 32 central banks have cut rates in 2019 and estimates suggest another 58 could before year’s end. Why do central banks cut interest rates? Why do central banks buy securities (sometimes referred to as quantitative easing)?
The simple answer is that central banks cut interest rates in an attempt to prevent a slowdown in economic activity. As interest rates drop, borrowing becomes cheaper. Theoretically, as companies and individuals borrow cheap money, they use it to hire new employees, add products, purchase things, etc., thus boosting economic activity. In addition, when a central bank purchases bonds in the open market, they hold the bonds on their balance sheet and credit the member banks the funds used for the purchase. This cash injection provides member banks additional funds which can be loaned out, in order to stimulate business activity. However, is there a point of no return?
Some argue that the central bank stimulus policies have not worked as planned and funds have not been directed toward products and services but rather have propped up the equity and bond markets. As interest rates continue to fall around the globe, it may be good for borrowers but a detriment to savers, pension plans and retirees. Although the central banks are attempting to push consumption, they may be getting the opposite results. Individuals at some point are forced to direct more of their income into savings to pay bills or build on their retirement funds. Investors also seek alternative means to make up for the lack of interest being earned, perhaps adding unwanted risk in their investment portfolio.
On September 12th, the European Central Bank will announce changes to their monetary policy. Expectations are that the ECB will cut interest rates further and potentially renew asset purchases. The likely consequence would be even lower rates in Europe causing even more interest rate pressure domestically. Lower rates abroad have made the dollar stronger which in turn has made U.S. products and services more expensive. As many of the worldwide economies push rates lower, it may force the Fed to keep pace or suffer the consequences of U.S. corporations not being able to compete. In other words, our rate environment may be being influenced more by global conditions versus our own economy.
Regardless, the important investor message is to not be sucked into the black hole. Investor discipline is required to maintain the core portfolio and avoid alternative temptations and temporary fixes. Individual bonds, even with lower yields, provide principal protection in a way not possible with many alternative strategies. An investor always has the option to hold an individual bond to maturity. Volatility and associated market risks are avoided in that the individual bond will maintain its known yield, defined cash flow and date when its principal is returned when held to maturity. Remember, fixed income investing is about the long term. Given the current global economic conditions, fixed income allocation may best be focussed on return of principal instead of return on principal.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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