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Low Rates Are Here to Stay

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For a long time, investors have expected interest rates to reverse their long trend downward and start rising again. But income-starved savers who have hoped against hope that the economic recovery would finally force rates upward shouldn't hold their breath, because those rate hikes are likely getting further away rather than closer.

Reading the Fed
Ever since the financial crisis, the Federal Reserve has been as accommodative in its interest rate policy as mathematics allows. It didn't just reduce its Fed funds rate to near zero; it tossed in two rounds of quantitative easing -- and counting -- to try to push long-term rates downward as well.

But as the economic recovery took hold, many saw a light at the end of the low-rate tunnel. Pointing to rising commodity prices and hawkish comments from a number of Fed officials, those looking for the Fed's extended period of exceptionally low rates to give way to tightening monetary policy thought that things would finally go their way.

Then the Japanese disaster happened, and the U.S. stock market halted its huge six-month rise and corrected fairly violently. Those two events have had a profound effect on rate expectations for the near future.

What the future(s) will hold
One way to tell what experts think about coming rate moves is to look at the Fed funds futures market. By looking at prices for the futures contracts for various months, you can tell when investors believe the Fed will make its next move.

Until the crisis, most expected the Fed to start tightening early next year. But after the Japanese disaster and the ensuing correction in the stock market, traders have pushed out those expectations toward the middle of 2012. Based on yesterday's closing prices, futures traders expect Fed funds to reach 0.5% in May 2012, moving up to 1.25% by the beginning of 2013. And that actually reflects some optimism after yesterday's recovery in stocks; Wednesday's trading suggested a somewhat smaller chance of early rate hikes.

How to deal with low rates
Although the Fed's exact timing isn't critically important, what market participants are telling you is that those higher interest rates you've been expecting for a while may hold off for a while longer. That has ramifications for certain types of investments. In particular:

  • Winner: Mortgage REITs. Ultra-low short-term rates are critical for the interest rate spread plays that Chimera Investment (NYSE: CIM  ) and American Capital Agency (Nasdaq: AGNC  ) rely on to produce their stellar profits and huge dividend yields. The longer they last, the longer the dividend gravy train will keep on chugging for shareholders.
  • Winner: Banks. Similarly, banks love to pay depositors next to nothing and lend at higher rates. Over the past five years, Citigroup (NYSE: C  ) and M&T Bank (NYSE: MTB  ) have seen sizable jumps in their net interest income, thanks largely to higher spreads produced by the Fed's interest rate cuts.
  • Loser: Cash-rich companies. If you're a borrower, you love low rates. But companies that have huge amounts of cash on their balance sheets can't get much income from it in low-rate environments. While it's unfair to pin all the blame for weak performance from Cisco Systems (Nasdaq: CSCO  ) and Microsoft (Nasdaq: MSFT  ) on low interest rates, it certainly isn't helping the tech stalwarts to have tens of billions of dollars earning next to nothing.
  • Loser: Insurance companies. Insurers will have to deal not only with the aftermath of Japan's earthquake but with the ongoing challenge of investing their float at rock-bottom rates. Companies like Travelers (NYSE: TRV  ) have blamed low rates for reductions in their net income and foresee more trouble ahead as long as rates stay low.

Do the right thing
Whether you're a winner or a loser from low rates depends on your particular situation and how you invest for it. If you're relying on bank CDs and other safe income investments, you're in a world of hurt right now, and it could well get worse before it gets better. But if you seek out the winners and losers from the rate environment you expect in the months and years ahead, it can help you adapt your portfolio to generate the best returns possible no matter what the future brings.

Keep your eye on rate-sensitive stocks by adding them to your watchlist:

Don't have a watchlist? Sign up now and you'll get immediate access to a new special report, "6 Stocks to Watch from David and Tom Gardner." Click here to get started -- it's all free.

Fool contributor Dan Caplinger hopes he's not the contrarian indicator that rates will jump tomorrow. He owns shares of Chimera Investment. Motley Fool Options has recommended a diagonal call position on Microsoft, which is a Motley Fool Inside Value pick. The Fool owns shares of Microsoft and has created a bull call spread position on Cisco Systems. Motley Fool Alpha owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is definitely here to stay.


Read/Post Comments (5) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 18, 2011, at 3:04 PM, ibuylowandsellhi wrote:

    Now I know rates are going to go up rapidly. We have a so-called pundit claiming that, 'this time it is different.' Oh, the young Fools that don't learn from past pundit predicaments!

  • Report this Comment On March 18, 2011, at 3:05 PM, ibuylowandsellhi wrote:

    I forgot to add, "I'll bet you a dollar you are wrong!"

  • Report this Comment On March 18, 2011, at 4:24 PM, HectorSector wrote:

    Japan had its own real estate crash in the early 90s. Since then the Japanese discount rate has 0.25% or lower for 15 years; it's been 0.10% for ten years. Since we Americans still haven't come to grips with our own real estate and fiscal problems, it's entirely possible that interest rates here could be extremely low for another ten years.

  • Report this Comment On March 19, 2011, at 8:01 PM, DividendDude wrote:

    You are correct fellow Fool - there is an unprecedented opportunity now to be making an excellent dividend return from this type of investment. And, except for ibuylowandsellhi, we Fools don't know the future RATE at which interest rate will go back up. But we know the PRESENT, and the easy money is very nice - so long as you don't go into mortgage REITs expecting any capital appreciation.

  • Report this Comment On March 21, 2011, at 7:27 AM, dbtheonly wrote:

    "ibuy..."

    Before I cover that bet, you'll have to give me a time frame & some specificity.

    I doubt that anyone will dispute that interest rates will go up. Eventually. How eventual is eventually? 1 month? I'll cover the bet. 6 months? A year? 5 years? No, I'm not covering out that far.

    Equally I need to know what you mean by rapidly. An increase from .25% to .5% could be called a doubling or 100% increase. It's the same math as used in penny stocks. you can get some humongous percentages. Is that rapid?

    Finally you'll need to define interest rates more concretely. Credit Card rates are all over the field, mortgages are still within a fairly narrow range.

    It's easy to slogan. Facts are more inconvenient.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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