Pioneer Wealth: Economic Commentary

Over the last couple years we have witnessed a large drop in interest rates because of the economic conditions. Interest rates move in regular cycles these days. Generally in reaction to whats going on in the macroeconomic environment. The basics are when the economy is growing very quickly the Fed raises interest rates to slow that growth not wanting the economic growth to lead to inflation. When the economy is dropping very quickly, the Fed decreases interest rates in the hope that people will borrow money at a low cost to invest in businesses or just spend as the case may be.

We are now at a very low point in interest rates as some of you may recognize based on what your savings accounts are earning now compared to 2 years ago. The chart below illustrates the changes in interest rates based on the fed funds rate since 1971. As you can see we are currently at almost a 40 year low. So what does this mean for our investments?

Fed Funds Rate 1971-2009

A couple things that are very important to consider. 1) Mortgages and 2) Bonds.

1. Mortgages

• As interest rates have gone down to these record lows we have seen a huge uptick in the amount of mortgage refinances. The truth is that borrowing money to purchase a home is cheaper now than it has been in the last 40 years, and these loans cant get much cheaper in the future. This may be a once in a lifetime opportunity to get this type of loan.
• The danger here is because interest rates have been so low in the last decade and continue at low rates today, we have built a basket of houses and real estate in general that has a value much different than the value was over the last 40 years. The value of real estate is based on what the demand for it looks like. When we are making borrowing money this cheap and over the last decade incredibly easy to do, we have artificially inflated the value of real estate. There is a huge question about what the real value of real estate should be. No one knows the answer to this. Economists are working on various formulas but the basics are the current value was based on cheap and easy loans. If cheap and easy loans dont continue the demand will go down and the prices should follow. How far down the real value lies is still undetermined
• So while interest rates are low, I would not recommend just buying any house at its asking price because borrowing money is cheap. What I would recommend is buying real estate that is selling at 50% of what it was selling for 1 or 2 years ago. This may seem like a ridiculous statement, but we have seen many clients doing this in the last 1.5 years. It just takes a little homework.

1. Bonds

• A bond is simply a company or government borrowing money from people. They promise to pay you, the investor or bond holder, a certain interest rate for a period of time. The period of time is called the maturity date. Lets look at an example.
• Example 1:  Lets say the state of California wants to borrow money to build a bridge. They know that they can pay back the money over the next 10 years. They also know that their finances dont look so good these days so investors will probably demand a higher interest rates than some other states. The issue a bond that has a 10 year maturity and pays 5% annual interest.

Well, in todays market where our savings accounts earn 1% if we’re luck and most state bonds pay around 3.5%, a 5% interest rate is pretty   attractive. Lets say we buy this bond. Lets also say that by 2012 interest rates have gone up and savings accounts now earn 5% interest like they did 2 years ago. What happens to our bond? Our bond is now less attractive than when we bought it. So the value of our bond goes down. If we wanted to sell it we would probably get less than what we paid for it.

So what do we do to try to prevent a loss in value of our bonds. The only solution if we still want bonds in our portfolio is to buy shorter term bonds. The idea here is that if those interest rates are indeed going up, a bond that matures in 6 months can be liquidated and used to buy a new bond at a higher interest rate. We can continuously do this until interest rates get to a level that we are comfortable with, and then lock in some longer term bonds/cd’s/ or anything that has a fixed interest rate.

So the conclusion here is we know interest rates are at all time lows. We know that they cant go anywhere but up. We could take advantage of this situation buy getting low cost mortgages on great deals in investment properties, but have to watch out for artificially inflated values. We could protect ourselves against the risk of losing value in our bonds by switching to shorter term bonds until interest rates rise to a more normal level.

As always, it is recommended to talk to your financial professionals for more details and to see what makes the most sense in your particular situation.

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