Episode 25 - Discussion on Interest Rates
In this episode of Blue Money, Kevin & Jim have an in-depth discussion about interest rates. Kevin starts off by explaining how inflation and interest rates are related, and he explains the reasoning behind it. Jimmy explains what “The Fed” is.
The guys discuss how interest rates affect the stock market and bonds. It’s eye-opening when Jimmy points out how much of a difference just one percent can make over the lifetime of a loan. Kevin uses recent historics to predict the future economic climate over the next year. Kevin & Jim close out this episode with advice and actions you should be taking now.
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Episode 25 – Discussion on Interest Rates
This is Blue Money, a finance podcast made for cops by cops. With us, you know your money’s safe. Lieutenant Jim Donnelly of the Bensalem Police Department and co-host Kevin McGarry of Valley Financial Group, come together to help protect and serve your financial needs. This is Blue Money.
Jim: I want to welcome everyone back to the Blue Money Podcast. This is your host, Jim Donnelly. I’m here with my co-host, Kevin McGarry.
Kevin: Jimmy, what’s up bud?
Jim: Not much, Kev. The topic I thought today we would go discuss is about interest rates and we always see how the Fed’s raising them or loan and how it affects the stock market bonds. So, just hit upon that real fast, Kevin, about interest rates and why they do that, why the Fed controls are higher and lower.
Kevin: Yeah. Before we dive into that, do you ever go to a coffee shop?
Kevin: You never go to coffee?
Jim: I don’t drink coffee, man.
Kevin: I mean, coffee’s foreclosure. What they say, Jimmy. But I was in the coffee shop today, and the person in front of me, I was being patient, she put in like 26 sugars in that coffee. 26. You know how long I waited for that?
Jim: Who were you to judge? You had like 15 [inaudible 00:00:50] tonight, are you going to judge her for coffee?
Kevin: It’s just this, there’s small space at the coffee shop and you’re trying to rush here, but anyhow, I was just thinking about that, patience. So, go back to the question. Interest rates.
Jim: Yeah, pretty interest rates. Why are the fed, why they controller? Obviously we know it’s the number one tool they have to control the monetary policy that they really oversee, and that’s the one tool that the disposal that they use the most. So interest rates, how’s it affected it? What do you think? And why they do it?
Kevin: Yeah, I mean, the simple thing for this last time, the Fed raised over the last two years, 11 times. Why did they raise rates? We were at 40 year highs in inflation. Their job was to control inflation and they’re trying to get inflation down. So, how did they do that? They increase interest rates and this time the Federal chairman, Powell, he was, they were pretty aggressive, really aggressive actually. They want to get inflation to around two. And that’s what they’re striving to do. Why do they do that? It’s quite simple. They want to increase borrowing cost. They want to increase debt services. They want to slow down the consumer and corporations in spending. And if you slow down spending, there’s more goods out there and it drives down prices.
Jim: I think it’s important to tell everyone, especially the audience, the police officers that really ain’t familiar with who sets it. And it’s obviously, we always say the Fed, who’s the Fed? It’s the Federal Reserve board. I mean, they meet and they come up with fund. It’s usually the federal funds rate. And that has ripple effect across the entire economy. And usually it takes 12 months for that effect to hit the economy. It doesn’t happen overnight. However, the stock market usually feels the effect instantly. So, can you hit upon that Kev, why when they set this, it usually takes 12 months to get their point across, however the stock market reacts instantly?
Kevin: Yeah, I think you take a step back there. I think it varies in all different circumstances, going back to history when the Fed raises rates, but there’s multiple reasons why it could impact the stock market is one is, you can get a higher rate on a bond, you can get a treasury of 4 or 5%, 6%, and you’ll see, hey, there’s more risk in that stock. I’ll take it out and I’ll invest it in something that is perceived risk free.
Jim: Yeah, that’s absolutely right, Kev. That’s a lot of thing I read about it is why would it affect the stock market? And I went to look and exactly, I kept seeing it pop up. Why have the risk in the stock if you can put it in a savings account or a bond or something that’s going to lock in guarantee money, why have the risk? So, that’s just really for all the police officers to understand out there. Why do stock market does take a hit when the interest rates go up. Now what about the bond market, Kev? How does that affect that with interest rates?
Kevin: Yeah, I think it impacts it greatly. I mean, we’re in the third year of a down bond market. I mean, right now, if you look at the I shares US core bond, ETF, the AG index, it’s down over 5% for three years. I mean, we’ve never had a down three year period in bond market. Last year in 2022 was the worst bond market on record. You had to go back to Napoleon when the bond market did as bad as last year. And then it was down a little bit in 2021 as well. So, this is the third year that we’ve been down. And I think the reason is why is it impacting bonds? Well, as we explained in previous podcasts, when interest rates rise the prices of the bond go down and vice versa. When they go down, rates go down, bond values go up. I mean, the thing is with a lot of clients right now, Jim, when they sit down and they speak to us, I thought bonds were supposed to be safe. You see a bond index down 13%. Relative to stocks, they have less downside, potential risk than stocks, but they’re not guaranteed not to go down. But to explain this simply to the listeners out there, how do we measure the impact of interest rates, impact on the price of bonds? And we do that through bond duration. Bond duration is the measure of interest rate risk. So, in general terms, give an example here. For every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration. So, give an example, you have zero duration bonds move up or down, there’s no impact. So, let’s say your duration is two years of your bonds and interest rates go up 1%. What’s your bond going to go down? It’s going to go down 2%. Now you’ll have that yield on that bond to buffer that down, but it’s go back, save durations four and your interest rates go up a percent. What happens to your bond price? It goes down 4%. And if you look at six, hey, bond prices, my duration six, bond interest rates go down 1%, my bond will go up 6%.
Jim: No, it makes sense. Completely makes sense. I mean the one thing that I was shocked, not shocked to see, just surprised how much, when the Fed does increase the interest rates, just say like house prices. Say your family’s looking to buy a house, $300,000 house for a 30 year fixed mortgage and the interest rate is 3.5 for the lifetime of the loan. So, that’s basically comes to what the mortgage and the interest you’re looking at 485,000 in the 30 years they would pay, that’s 185,000. That would be for the interest, their monthly payment would be about 1340. Now let’s just say if the Fed says we’re going to raise rates 1% and it goes to 4.5% that loan over the 30 years, they’re going to be paying 547,000 just for one interest point higher, which will come to 247,000 in interest with a monthly payment of 1520. So, you’re looking at $200 more a month and you’re going to be paying a lot more in the interest through the loan just because of 1% and you don’t realize it. So, that’s why I thought it was important. The next podcast we’re going to have Paul Scholars come in here and talk about interest rates and see how they’re affect on it.
Kevin: I think the big thing there is it’s real, so cashflow’s key for most of our clients and their families. And you see someone that has a 700,000, a million dollar home, but they took an equity line out on that equity line is a variable interest rate and what you’re seeing, those interest rates go up, they were 4 or 5%, now they’re eight, 9%. So their payment just doubled.
Jim: That’s crazy.
Kevin: And that impacts the cash flow. So, the one thing we’re looking at for our clients and potential clients out there, just any of the listeners, how do we protect against that? And that’s where when interest rates tried, debt services go up, cash flows goes down and slows down the economy. But here’s the thing, rising rates and the Fed being aggressive with monetary policy, bit of major headwind for the economy. But when the Fed slows down or pauses and from the last interest rate, the 12 months following the last interest rate, the economy’s done pretty well. The market’s done well. On average it’s done 14% and it’s up 75% of the time. And if you look at the 10 year treasury from when the Fed pauses or stops raising rates from the last one, the next 12 months, the 10 year treasury goes down a hundred basis points, which is 1%, which is positive for bonds. So historically, where we are today, you would believe or perceive that the Fed is done raising rates, even though Powell yesterday came out and said, hey, inflation could give us some head fakes and the market went down. But in reality we just had 11 hikes. What’s the likelihood we’re going to have more? And if it is the last one, the following 12 months for both bond and stock markets have been traditionally pretty good.
Jim: So, what do you recommend Kev for the police officer out there looking at their portfolio and you’re hearing about the interest rates going up? Do you think they should take a look at it? Do you think they should just stay the course, stay off it, talk to someone? Like what’s your advice for that with the portfolio?
Kevin: I think for one portfolio, as you know we’re long-term investors. Is it a sound long-term investment portfolio to meet your needs and it’s tracking to accomplish your goals, that’s what we’re looking at. I mean, if you have duration risk on there or you have interest rate sensitive stock holdings, you may want to look at it. But it’s just always making sure you have a financial plan and that portfolio meets that financial plan. That’s what I would recommend.
Jim: Yeah, I think you’re right Kev. I think, for the police officers out there, just stay the course. Don’t let all the noise, don’t worry about the interest rates. Don’t worry about the election next year. Don’t get caught up in all the noise. We’re long-term investors. This is a marathon, it’s not a sprint. Just stay the course. Keep just pumping money into your accounts. Try to maximum out and state. Of course, like I said, it’s a long time now if you’re going to retire or you’re in drop and you’re getting worried and just talk to someone.
Kevin: Yeah, I agree with that. The other thing is, look at your credit cards, look at your mortgage. Look, if you have an amount, make sure your rates are in check because these rates are going up and have gone up and we’ve seen, hey, credit card use and debt in the US is over a trillion dollars now for the first time. People are spending money, saving rates down, credit card use is up. That’s interest rates, it’s a killer.
Jim: You know what holidays coming, buddy, Christmas is coming with them. Credit cards. So, man, stay away.
Kevin: A lot of Santa Clauses out there.
Jim: So Kev, what do you want guy people to remember? The police officers out there or anyone listening to our podcast? What’s a couple takes that you want them to take away from this podcast today?
Kevin: I think, number one, make sure you’re getting more. Because interest rates are higher if you have cash there, we didn’t really dive into it, but I do think it’s important. Savings accounts are very low checking accounts you can get four to 5% out there. So, make sure your cash is earning money, number one. Number two make sure your portfolio’s diversified. It meets your needs, don’t panic over that, but right now I would be reviewing all my debt and make sure my rates have not increased because a lot of times you’re busy living and credit card A, B, C, their rates jumped on you and you don’t even know it. So, you could save yourself a lot of money.
Jim: Stay on top of that. So, I want to thank everyone listening to the Blue Money Podcast today. But anyone has any questions about this podcast or the portfolio in general, please don’t hesitate to reach out to Kevin and I. We’re always here, so be safe out there. And thank you for listening.
Kevin: Be safe.
Thanks for listening to Blue Money. To learn more about Jim and Kevin or for a free financial assessment, visit valleyfinancial.com or click on the link in the podcast description or show notes. Until next time, safe investing.
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