Federal Reserve Discount Rate and Your Investment Decisions

Sam Subramanian PhD, MBA

Last week the Federal Reserve announced that it is raising the interest rate it will charge financial institutions when they borrow from their regional Federal Reserve Bank. The Federal Reserve raised the discount rate from 0.5% to 0.75%.

This is the first change in the discount rate since December 2008.

Commenting on the decision, Federal Reserve said that U. S. banks are in a stronger position now and no longer need an emergency source of cheap funding.

How should you change your investment decisions in response to the increase in the discount rate?

After nearly 14 months, the Federal Reserve has raised the discount rate by 0.25% to 0.75%. The move removes cheap source of emergency funds made available to banks during the financial crisis.

U. S. Stock Investment Decisions

Since early stages of interest rate increases often coincide with an improving economy, U. S. stocks tend to gain modestly during such periods. From 1946 to 2009, stocks on average gained 2.6% six months after the beginning of a rate hike. From a sector perspective, technology and healthcare have often fared well during such periods. Technology Select SPDR (XLK) and Health Care Select SPDR (XLV) are plays that have history on their side.

While history does not favor utilities, they could be due for come back. The Utilities Select SPDR (XLU) has lagged the S&P 500 by nearly 19% since the start of 2009. Weak industrial and residential demand has hurt utility stocks. This could change once signs of economic recovery become obvious. Utilities on average currently yield over 4% providing an opportunity for investors to boost current income.

How the Discount Rate Impacts Foreign Stocks and Commodities

A falling U. S. dollar has been a tailwind for foreign stocks and commodities over the past few years. This could change. The Fed's recent move has bullish implications for the U. S. dollar. Investors also appear to be recognizing the larger fiscal problems in Europe.

The prudent course of action would be not fall too much in love with foreign funds like Fidelity Spartan International Index (FSIIX), foreign ETFs like iShares MSCI EAFE Index (EFA) and commodity ETNs like SPDR Gold Shares (GLD) or United States Oil (USO).

One way to mitigate the impact of a rising U. S. dollar is to own companies like Infosys Technologies (INFY) that benefit from a stronger greenback. Aggressive investors can take the short-side of the commodity trade through leveraged, inverse ETFs like Ultra Short Gold ProShares (GLL) or Ultra Short Oil and Gas ProShares (DUG).

Investing in Bonds and Money Market Funds

Unless inflation pressures perk, the Fed is likely to wait for the job market to improve before raising interest rates for households and businesses.

The status quo in the bond and money markets is likely to prevail in the near-term. The risk of yields on longer maturity bonds climbing persists. Dividend yields and interest rates will remain essentially elusive on money market and savings accounts.

Short-term bond funds like Fidelity Short-Term Bond (FSHBX) and inflation-protected bond investments like Fidelity Inflation Protected Bond Fund (FINPX) or iShares Barclays TIPS Bond (TIP) continue to remain alternatives for investors to increase current income. Assuming the economy continues to improve, including a dose of high-yield bond ETFs like iBoxx $ High Yield Corporate Bond (HYG) or SPDR Barclays Capital High Yield Bond (JNK) can be a good idea for some investors.

With the Federal Reserve raising the discount rate, here is the bottom line for investment decsions: Tread cautiously in both foreign and U. S. stocks, keep adequate cash, and look to short-term bonds, TIPS, and utilities to provide current income.

Related articles:
Utility ETFs and Stocks: Should You Buy, Sell, or Hold Utilities?
Exchange Traded Funds: Best, Worst, and 2010 Forecast

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