Investors hungry for income wonder when quality fixed-income will return to the menu. They’ve been wondering for the past six years. They could be wondering for the next six years.
Back in 2008, the Federal Reserve made it its business to wring yield out of quality debt investments. Mission accomplished. To find quality fixed-income with a yield above 3% without having to go out three decades is nearly impossible. As for the short-term stuff, it barely elicits a sniff.
That’s all supposed to change this year. Nearly everyone believes the Fed will push the influential federal funds rate higher sometime this year. Once the Fed starts pushing, fixed-income yields will rise.
Call me circumspect.
The Fed has been hinting it would raise the federal funds rate for the past four years. Unemployment was key. Once the unemployment rate dropped below 6.5% rates would begin to rise. We blew past 6.5% a year ago, and nothing.
When the unemployment rate dropped below 6.5%, the Fed began urging “patience.” Retail sales and capital spending still weren’t up to snuff. Gross domestic product (GDP) remained wobbly.
In the latest Fed meeting of governors, “patience” was omitted. Now, “data” are key. If the data show a need for higher interest rates, the Fed will push for higher interest rates. But data are frequently like a Rorschach inkblot or the U.S. Constitution – it is what the seer says it is. In other words, I have no idea what data will spur the Fed to act, and neither does anyone else.
Moreover, it might not matter anyway.
In the past, an increase to the federal funds rate would pressure other lending rates to rise. Today, this seems unlikely. Banks borrow from each other at the federal funds rate to meet reserve requirements. The commercial banking system has $3.2 trillion in excess reserves.
With so much excess reserves on the books, there isn’t much demand for these interbank loans. Therefore, there is little reason for market rates to rise, even if the Fed raises the federal funds rate. What good will it do to raise the rate on loans no one wants?
Of course, this is just my take on the factors at hand. What if I’m wrong? What if interest rates rise?
Should interest rates rise, I still prefer dividend stocks to fixed-income investments.
If interest rates are rising, on the margin you will capture higher income, but at a cost. If rates continue to rise after you bought, you’ll suffer an immediate capital loss. Bond values move inversely to bond yields. You might want to wait awhile before jumping in the fixed-income market.
Rising interest rates are also frequently a byproduct of rising economic growth. Fortunately, a growing economy supersedes low borrowing costs in the grand scheme of things. Economic growth is an obvious plus for the overall stock market.
Dividend stocks – dividend growers in particular – might be the surest bet if interest rates rise. These stocks have historically outperformed in the wake of rising rates. According to data compiled by Ned Davis Research, three years after the Fed first hikes the federal funds rate, dividend growers have outperformed dividend nonpayers by over 17 percentage points.
If interest rates don’t rise, I like dividend stocks for their high immediate income. If interest rates do rise, I like dividend stocks for their rising payout stream. Heads we win, tails we win, at least for 2015.
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