Rising Rate Jitters: Why?

The Federal Reserve may raise interest rates slightly this fall. But all in all, deflationary pressures, lower rates abroad and threats from a strong dollar do not portend sustained and significant Fed hikes.

Whenever there's a hint of the Fed boosting rates, markets slump. In our view, stock and bond nervous nellies assume a case worse than reality. Plus, stock traders may see a small rise as a signal the economic fundamentals are stronger in the Fed's eyes. On Wall Street, a negative can become a positive in an instant.

The guessing game of the summer is exactly when will the Fed raise its federal funds target rate from the 0% to 0.25% floor, where it has stayed since December 2008 ? Low interest rates have persisted since the financial crisis as the Fed primed our slower-than-average recovery with easy money. With early August reports of steady job gains , speculation is rising that the Fed may increase interest rates, possibly as early as September. What might that mean to you as an investor or borrower?

The fed funds rate is what banks pay to borrow funds overnight from the Fed to meet reserve requirements, the amounts they must hold to safeguard deposits. Banks apply the fed funds rate in determining all other short-term interest rates. In essence, our central bank may increase the cost of money.

This affects the prime rate ( currently 3.25%), which banks charge their most creditworthy customers, and rates charged on bank loans, credit cards and adjustable-rate mortgages. It also influences the rates paid on savings and checking account deposits. Longer-term interest rates are indirectly influenced, as rising short-term rates pressure yields of longer maturity securities, such as the 10-year U.S. Treasury note.

The current level is as low as the fed funds rate can go. Toward the end of the stagflationary 1970s, then-Fed Chairman Paul Volcker boosted the fed funds rate to 20% to fight inflation. The prime rate peaked at 21.50%, an all-time high, from Dec. 19, 1980, through Jan. 2, 1981. We are not likely to see anything like that any time soon. Far from it.

Normally, the Fed increases the cost of money to tame inflation. This time the call is for "normalization," the idea that abnormally low interest rates are distorting the economy and it's time to get back to normal, restoring market forces and backing off from easy money. Making borrowing almost free spurs risk taking and the potentially unwise use of debt financing. Conservative savers are penalized by yields that in many cases are negative, adjusted for inflation and taxes.

Rising interest rates pressure fixed income investments as bond prices in general move inversely to increases or decreases in interest rates. The so- called bond vigilantes watch the yields on two- and 10-year Treasury paper, in particular.

Right now, two-year notes sport a yield of 0.62%; 10-year notes, 2.05%.

Speculation centers around a potential quarter percentage point increase in the fed funds rate. However, there is little potential for rates in general to shoot higher.

Inflation continues below the Fed's target rate of 2%. The trailing one-year core inflation rate is running at 1.8%, with all-items inflation far less than that. Yes, core inflation numbers omit food and energy, and while gas prices are tamer, drug and tuition prices and a few other things you use are rising in price, but we are talking about government statisticians who live in an alternate universe.

As an inflation hedge, gold is tarnished, having dropped to around $1,100 lately from a high in September 2011 of $1,921. Depressed gold prices signal expectations of low inflation and a strong dollar.

The municipal bond traders at Belle Haven Investments in Rye Brook, NY, note 17 developed nations with 10-year yields on government paper lower than America's. Eight nations offer yields less than 1%, making U.S. yields over 2%, along with a strong credit rating, relatively attractive, spurring dollar strength.

The strong dollar is a bonanza for tourists headed abroad, but the stock market is not enthusiastic. A little less than 40% of Standard & Poor's 500 corporate revenues come from overseas , and the bulked-up greenback makes our products less competitive in world markets. Plus, domestic firms have to compete against cheaper imports, pressuring profit margins.

None of this portends a need for much higher interest rates in the U.S.

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Lewis Walker, CFP, is president of Walker Capital Managemen, LCC in Peachtree Corners, Ga. Securities and certain advisory services offered through The Strategic Financial Alliance Inc. (SFA). Lewis Walkerand Mike Hostetler are registered representatives of the SFA, which is otherwise unaffiliated with Walker Capital Management. 770-441-2603. lewisw@theinvestmentcoach.com.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.