The U.S. Federal Reserve raised key interest rates last week, to a range of 1.75%-2.00%.
This is the seventh interest rate increase since the Fed started raising rates in late 2015. Each raise has been 0.25%.
In addition, the Fed signaled that they may raise interest rates two more times this year, rather than just one more time, depending on continued economic strength.
Currently, the United States has a 3.8% official unemployment rate, which is the lowest since 2000. Economic activity remains robust, mild inflation has surfaced (the Fed raised their inflation estimate from 1.9% to 2.1%), and most recession indicators suggest that a recession is unlikely to occur for the rest of 2018. This all leads the Fed to confidently raise rates to keep inflation in check.
Impacts of Higher Rates on the G and F Funds
In general, rising Fed interest rates translates into higher interest rates for U.S. treasuries and other bonds. Here’s the 10-Year treasury rate:
The G Fund provides returns that nearly match 10-year treasury yields, so higher rates generally translate into better G Fund returns. And the best part about the G Fund is that because of the uniquely liquid nature of the fund, it has little or no interest rate risk, unlike 10-year treasuries.
However, despite benefiting the G Fund, rising rates can also mean mild trouble for the F Fund. Over the past 12 months, the F Fund is the only fund that has given investors negative returns:
This is because the F Fund has bonds that mature in an average of 5.75 years. And as the F Fund factsheet describes it: “The average duration of the U.S. Aggregate Index was 5.75 years, which means that a 1% increase in interest rates could be expected to result in a 5.75% decrease in the price of a security.”
The F Fund currently gives investors 2.72% per year in interest. But when the Federal Reserve increases interest rates, newly-issued bonds start offering higher yields, which means existing bonds must decrease in price to offer the same yield for the same type of bond. The bond value starts going down even as it continues to give investors interest. And total returns from a bond fund are based on the changing prices of those bonds and the interest they provide.
At the rate that the Fed is currently raising rates, F Fund returns should be mildly negative, which is what we see happening.
When interest rates are rising like we see now, it’s generally safer to have money in the G Fund than the F Fund. After taking into account inflation, the G Fund is barely producing positive returns, but at least it’s not negative.
In a recessionary environment when the Fed starts reducing interest rates, the F Fund is likely to outperform the G Fund, and the F Fund historically mildly outperforms the G Fund over long periods of time.