By: Lyn Alden
December has been relatively flat for the TSP so far, with just mild gains for most of the funds.
The C Fund is up the most at 1.4%, while the S Fund is up only 0.6%, and the I Fund is up a little over 0.6%. The G Fund is up a tiny fraction of a percent so far in December, while the F Fund is down a tiny fraction of a percent over the same time period. This mild decline in the F Fund is most likely due to rising interest rates.
G and F Funds News: The Fed Raised Interest Rates Again
Earlier this month, the Open Market Committee of the Federal Reserve voted to increase the federal funds rate from 1.25% to 1.50%. This will eventually impact most interest-bearing securities, such as mortgage rates, bond rates, savings accounts, and other types of consumer and corporate debt.
The Fed has been raising interest rates 0.25% per instance a few times per year starting in 2015, and has raised them from near-zero to 1.50% in total over the last couple years. They expect three more increases before the end of 2018, which would bring the federal funds rate to 2.25% by that time.
Over the long term, this should translate into higher interest rates for the G Fund and F Fund. However, in the shorter term, rising interest rates negatively impact existing bonds with long maturity dates, such as the F Fund that holds bonds with an average maturity of over 5 years. So it’s not surprising that we saw a very mild negative F Fund return so far this month. Fortunately, this gradual pace of interest rate increases of about 0.75% per year should avoid causing any negative F Fund returns over a full year.
The 10-year treasury yield, as well as the G Fund rate of return (which is highly correlated with the 10-year treasury) has been relatively flat over the last few years despite these rising interest rates. All else being equal, increases to the federal funds rate should eventually translate into rising rates for these investments.
However, the primary factor that is negatively impacting the 10-year treasury yield and the G Fund rate of return is that the yield curve is starting to flatten out, and is getting closer to inverting. Put simply, long-term bonds generally give higher interest rates than short-term bonds because they lock down money for a longer period of time. However, in the year or two before recessions, the yield curve historically starts to flatten out and eventually inverts to below zero, meaning that for several months long-term bonds actually give lower interest rates than short-term bonds, because there is more demand to lock in long-term bond rates in the face of what may be an upcoming recession where interest rates are decreased once again.
Every recent U.S. recession has been preceded by an inverted yield curve. This chart shows the difference between 10-year and 2-year treasury rates, with recessions shaded in gray:
Some analysts believe that this flattening-out of the yield curve means it will invert and then we’ll have a recession within a couple years. Others believe that a recession may come even sooner, because in such a low interest rate environment the yield curve might never invert ahead of it. Japan, for example, has had low interest rates for a very long time and their yield curve stopped inverting before recessions; it merely flattens out to a low difference like we have now. Still others believe that tax cuts or other factors may prolong the time it takes for another recession to arrive.
Whatever the future may bring, the fact is that the rising federal funds rate is currently resulting in sharply increased short-term bond interest rates (like the 2-year treasury), but long-term bond interest rates (like the 10-year treasury) are generally remaining flat, resulting in a flattening-out of the yield curve as the above chart shows. The G Fund has therefore not really had a significant positive impact from rising interest rates yet, since it is highly correlated with 10-year treasury yields.
C and S Funds News: Corporate Tax Cuts
Both houses of Congress passed and the President signed a tax reform bill that among other things substantially reduces the corporate tax rate from 35% to 21%. This means that the effective corporate tax rate will be reduced from approximately 20% to perhaps as low as 10%.
This will boost the after-tax income of corporations in the C Fund and S Fund, and therefore can slightly reduce the historically high valuations on those stocks. We’re not seeing big stock price jumps at the moment because the tax bill was almost fully accounted for in stock prices leading up to its passing.