Rising Rates and Shrinking Balance Sheets Pose Risks Ahead

The following is a summary of our recent Big Picture broadcast, which can be accessed on our site here or on iTunes here.

The Fed seems dead-set on raising interest rates further and this is putting the squeeze on borrowers, savers, and investors. This time on Financial Sense’ Big Picture segment, Jim Puplava discussed the impact of rising rates, how savers are losing purchasing power given the current rate of inflation, and what he's doing with his clients in light of today's investment environment.

Rising Rates, Shrinking Balance Sheets

The Federal Reserve is raising the prime lending rate and, as it does so, rates for many loans are going up as well.

“If you are a borrower, it’s going to cost you more money to borrow it,” Puplava said.

Another rate hike is possible in June, Puplava noted. However, this isn’t the only impact the Fed is having on interest rates. Eventually, the Fed will keep raising rates and lead us into another recession, he added.

The Fed may also start tightening in another way. “For every half-trillion dollars that the Fed shrinks its balance sheet, it’s equivalent to a 1 percent increase in the Fed Funds rate,” he said.

Right now, the Fed’s balance sheet contains about $4.5 trillion worth of debt. The Fed has indicated it wants to shrink its balance sheet down from $4.5 trillion to $2 trillion, which would imply a Fed funds rate of 5 percent, on top of any other rate hikes in coming months.

Savers Getting Squeezed

The yield curve, or the difference between short and long-term interest rates, hasn’t risen much as foreign buying holds the long end of the curve down. Banks make their profits based on this spread between what they pay depositors and what they charge borrowers. Because the yield curve has not been steepening, that spread is reduced.

Here’s the problem savers are facing: The highest rate out there on a 5-year CD is 2.3 percent. On a 10-year Treasury note, it’s a little over 2.3 percent. However, the inflation rate, or CPI, is running at 2.8 percent. Savers are making less in interest than what they lose in purchasing power given current inflation rates.

Also, investors have to consider their tax situation. The average American is between a 25 and a 28 percent tax bracket, Puplava noted.

If investors reside in a state where they don’t pay state income taxes, and if they’re in a 25 percent tax bracket, after paying taxes of 25 percent on a 5-year CD, their rate of return is reduced, and after inflation, they’re losing half a percent.

“On a 2.3 percent 5-year CD, you’re rate of return drops to 1.73 percent, after paying your Federal taxes,” he said.

In high income-tax states such as California and New York, investors’ returns would be 1.5 percent, meaning they’re losing 1.3 percent a year in purchasing power.

“That’s the key thing, and it’s one of the reasons why … it’s getting harder and harder for retirees,” Puplava said. “Rates have gone up, but they’re really not going up at the rate of inflation, and they’re not going up at the rate of increases in the Fed funds rate.”

Also, the fact that we’re not experiencing a credit boom means banks don’t have to compete for investors’ money, further pressuring savers’ rates of return.

What Should Investors Do?

Many more Americans today are delaying retirement because they can’t get a decent rate of return, Puplava noted.

“We used to think of a millionaire as somebody who’s rich,” he said. “To earn $3,000 a month, you need to have $2.8 million if you were investing in Treasury notes. For $5,000 a month, you’d need to have almost $5 million.”

In terms of his strategy, Puplava is no longer 100 percent invested in stocks. He’s between 20 and as high as 35 percent — depending on client objectives — between cash and bonds, he said.

Right now, he’s found floating-rate bonds to be most effective. These are generating between 4 and 5 percent returns and, as rates rise, returns will rise.

“The next move that we’re seeing is, as the economy begins to weaken, we’re going to see a rise in credit spreads between corporate bonds … and when that happens, we’ll probably go into short-term bonds because we’re looking for minimums of … 3.5 to 4 percent,” he noted.

What any good investor should do is start raising cash and start getting defensive as the market moves higher, he stated.

“If I can get 4 or 5 percent and not risk principal, I’d rather do that than … think we’re smart enough to know the final day that the stock market tops,” Puplava said. “That’s just not the way things work in the real world.”

Become a subscriber and also gain full access to our premium weekday interviews with leading guest experts by clicking here.

About the Author

fswebmaster [at] financialsense [dot] com ()