Moves to make as interest rates rise

April 21, 2006

Investment Consult

After a period of the lowest interest rates since folks watched black-and-white TV, rates have started to climb again. They went from under 1.0 percent in the closing days of 2003 to 4.6 percent today. The situation's worth a closer look, because it's not "business as usual."

Typically, when short-term interest rates rise, long-term rates (those locked in for more than 10 years) climb soon after. This time, however, US government long-term rates have barely budged, remaining at under 6 percent in most cases.

We've had negative yield curves in the past, at the same time that the Federal Reserve tightened the money supply, trying to curb potential inflation. But that's not what's happening now. So far, inflation has been remarkably tame, especially considering the enormous increase in oil prices. If the Fed continues to raise interest rates, squeezing the money supply further, it's possible we could have a recession.

Some experts think that the Fed just might indeed continue to raise rates. The Federal Reserve doesn't want the money supply to flow too freely, lest economic growth get out of hand.

Economic growth sounds inherently positive, but it's possible to have too much of a good thing. If growth accelerates too quickly, the argument goes, more jobs would be created, and unemployment would decline. Workers could demand and negotiate higher wages. Ultimately, corporations would raise prices, and we could wind up with an inflationary spiral.

Let's throw another factor into the interplay between interest rates and economic growth: housing prices. As interest rates rise, there's a good chance that home prices will decline. To some degree, people are spending rather than saving because they're counting on their rising home value to help finance their retirement. People who have made a ton of money on their houses feel wealthy.

If housing prices were to decline, however, homeowners could feel less wealthy, and could begin curbing their spending. That could result in a more sluggish economy, which brings the potential for recession.

Whatever the future holds, right now would be a good time to invest in vehicles that take advantage of short-term interest rates. Two such investment vehicles are short-term bonds and money-market funds.

Intermediate-term bond funds are another possibility, but I'd suggest that half of your allotment go to short-term bonds. Make sure your short-term and intermediate bonds are high quality, rated AA or higher. Avoid junk bonds and low-quality bonds.

Although many people think that all bond funds are pretty much the same, that's not the case: Returns and risk vary from fund to fund. I like the Pimco Total Return Fund, which currently concentrates its holdings in government and AAA rated intermediate-term bonds. With a five-year annualized return of 5.5 percent, and a one-year return of 2.7 percent, the fund is in about the top quarter of its peer group. The returns are good and are appropriate for the amount of risk incurred.