How Do Fed Rate Cuts Impact Your Portfolio?

In the summer of 1992, as a young student in economic history, I studied comparative economics at Georgetown University in Washington, D.C., and interned at a free-trade lobby. During my course of study, I had the opportunity to visit the Federal Reserve with a group of students to meet with a board governor and be briefed on the workings of the central bank of the United States. Of course, being young, I was more excited by the fact that I sat in Alan Greenspan's chair (nameplate affixed) at the Fed's conference room table than I was with what I was supposed to be learning. In any case, unlike impetuous students, investors need to be more concerned with the policy changes emerging from this room than with its personalities.

While many factors, such as inflation expectations and supply and demand, will impact interest rates, it's important to understand the Fed's role as well. The Fed's Federal Open Market Committee, currently chaired by Ben Bernake, regulates short-term interest rates with the aim of promoting economic growth (and thus employment) and stable prices (or modest inflation). To achieve those goals, the FOMC has three levers that it can pull: open market operations, the discount rate, and setting bank reserve requirements. Recently, investors have witnessed open market operations, in a series of fed-funds rate cuts (most recently a dramatic 0.75% drop to 3.5% on Jan. 22), as well as cuts to the discount rate, designed to stabilize uncertain bond markets and keep the economy from slipping into recession.

Each of these tools aids the Fed in regulating money supply and thus in either stimulating or reining in the economy. The biggest of the three is open market operations. The Fed can't declare interest rates by fiat, but it uses open market operations to get to the rate level it wants. If it wanted to lower rates, for instance, the Fed would increase the money supply. To do so, it would buy government bonds on the open market (this is why it is called open market operations), putting cash into the economy. When the Fed wants to raise rates, it shrinks the money supply by selling government bonds. The most meaningful interest rate that the Fed controls is the fed-funds rate, the short-term rate at which banks lend to each other. That rate is usually the tune by which the rest of the economy sings. If the fed-funds rate goes up, mortgage and credit card rates tend to do so as well--and vice versa.

In this week's The Short Answer, we'll look at how these Fed moves can impact your stock and bond funds and how staying diversified can serve you well, given the great uncertainty that often surrounds trying to guess where the Fed is going next.

The Fed's Impact on Stocks and Bonds
What the Fed does impacts both stocks and bonds. For example, a declining fed-funds rate has traditionally been a boon for financials stocks, which often depend on short-term borrowing to finance business operations. Consumer stocks could also get a lift, too, because lower rates mean that customers are less pinched. But keep in mind that interest rates aren't the only factor affecting stock prices. If the Fed's recent moves don't prevent a recession, consumer-focused stocks could get hurt.

But the relationship between interest rates and bonds is more straightforward. Rising rates are bad for bonds; bond prices fall when interest rates go up. The opposite is true as well, which is why bonds typically rally when the Fed cuts rates. One way to gauge a fund's sensitivity to interest rates is by taking a look at its duration. (You can find the average duration of any bond-fund portfolio on the Snapshot page of a fund report on Morningstar.com.) If a fund had a duration of 10 years, for instance, it means that the average price of a bond in its portfolio will either rise or fall roughly 10% for every 1 percentage point change in interest rates. There's more to how interest-rate fluctuations impact returns than that, but you get the idea.

The Fed Has Acted, Should You?
While the Fed has made some dramatic moves to try to revitalize our slowing economy, we'd suggest that investors exercise caution in attempting to take advantage of these developments. It might seem tempting to buy into a financials-sector fund, for example, to take advantage of a more beneficial environment for financial-sector firms (for example,  Citigroup's (C) stock price vaulted nearly 12% in the days following the Fed rate cut), but it's possible that the sector's troubles may be far from over. As we've written elsewhere, there are limits to the Fed's ability to solve our current mortgage-related crisis, because it's being fueled by factors over which the Fed only has tenuous control.

In the end, you never really know how the market will react to what the Fed does (or to anything else, for that matter). Rather than trying to play a guessing game that you'll be lucky to get right, it's better to keep your portfolio well diversified so it's ready for any environment. That means your portfolio has exposure to stocks of all stripes and isn't overly exposed to any one sector.  (You can use Morningstar.com's Instant X-Ray feature to help you see if you're making unintended bets on any one area of the market.)

You also might be tempted to pile into a fund that invests in long-term bonds, which are most sensitive to rate changes. But keep in mind that rates aren't the only thing that impacts the prices of bonds. A bond's credit worthiness can have a big effect, too. As a result, duration sensitivity is highest in Treasury issues (where there is effectively no credit risk) and can be much lower in the lower-quality region of the bond market.

Many bond-fund managers will tweak their portfolios in an effort to get ahead of Fed rate change actions. But as we've written before, getting interest-rate bets consistently correct and being able to adequately take advantage of those moves is extremely difficult. As a result, we suggest that investors pay as much attention to diversifying their bond-fund portfolios as they would to their stock-fund choices. By remaining diversified among a few bond-fund options, investors can be well positioned regardless of what direction Fed rate changes take. For instance, by holding a world-bond fund (possibly including emerging-markets bonds), investors can take advantage of foreign country central bank rate adjustments that don't necessarily sync with those in the United States.

If even the pros have a tough time figuring out where interest rates are headed in the short term and what effects they'll have in the future, your time is better spent finding investments that will likely do well over the long haul. Understand the risks managers will take, and the ones they won't, to help you determine whether a fund is right for you. Finding funds with talented and long-tenured managers, reasonable costs, and proven investment strategies (whether or not it involves making bets on interest rates) is difficult enough. You don't need to worry about what the Fed's doing, too.