Last week was a choppy one for the markets. Monday saw the largest one-day drop so far in 2019, with approximately a 3% decline for the C Fund and S Fund. The rest of the week clawed back most of those losses.
Lower Interest Rates for the G Fund
At the end of July, the Federal Reserve cut key interest rates for the first time in 12 years. As recently as December 2018, the Federal Reserve increased interest rates by 0.25% to 2.50%, but they have now taken that back to where it was at 2.25%. The bond market is pricing in a high probability of another 0.25% cut during the Fed’s next meeting in September, which would bring the rate down to 2.00% if it occurs.
Under normal conditions, the Federal Reserve determines the federal funds rate, which is the overnight lending rate between banks and is the key rate that they just cut by 0.25%. This very short-term rate trickles through the banking and bond systems and eventually affects longer-duration rates indirectly.
Historically, the Federal Reserve tends to increase this rate during periods of economic strength to tighten monetary conditions, promote saving, and prevent asset price bubbles and inflation.
During periods of economic weakness, they tend to cut interest rates as an attempt to stimulate the economy by making borrowing costs cheaper.
This chart shows the federal funds rate (blue line) and the 10-year U.S. treasury yield (red line) over the past three business cycles going back to the mid-1980’s, with recessions shaded in gray:
As you can see, despite the cyclical ups and downs along the way, interest rates have gradually decreased since the 1980’s. The three big interest rate cutting cycles, where the Federal Reserve lowered the federal funds rate by about 5% each time, occurred prior to and during recessions. However, there were also periods in the mid-1980’s and mid-1990’s where the Fed trimmed interest rates by a smaller amount, and then eventually went back to increasing them.
The G Fund interest rate is based on the weighted average yields of all Treasury notes and bonds of 4 years or higher, and in practice tends to closely match the popular 10-year yield due to its high weighting in the G Fund’s interest rate calculation.
As recently as late 2018, the 10-year yield increased to over 3.2%, and so the G Fund payout was similarly high. Throughout 2019 the world has had massive bond-buying pressure, which pushed long term interest rates down. The 10-year yield is now under 1.8%, which means G Fund interest rates are similarly low.
On the other hand, the F Fund has been the best-performing TSP fund over the past three months. Since the F Fund doesn’t hold bonds to maturity, it can make money or lose money from changing bond prices. As bond yields decrease, the prices of those bonds increase. For every 1% that interest rates decrease on those bonds, the bond prices within the F Fund go up about 5%.
Going forward, risks for U.S. and global equity markets are growing. The yield curve in the U.S. is mostly inverted, meaning that longer-duration bonds pay lower rates than shorter-duration bonds, and this historically tends to occur within a year leading up to a recession. Global growth is slowing as measured by various metrics. Equity valuations in the U.S. are historically high, and this has been the longest period without a recession in U.S. history.
It is time again to link to my article from last year about how to preserve TSP capital through difficult markets:
2 Smart Methods to Preserve TSP Capital
We could still see another big leg up in this market, like what happened after initial rate cuts in the 1980’s and 1990’s, but risks are growing to the downside. That doesn’t mean that investors should make sweeping changes and to try to precisely time the market, but it means that it is a good time to re-examine their risk profile and ensure that their portfolio is aligned for their age, risk tolerance, and financial goals.
It’s important to avoid making big changes when damage is already done, like selling stock funds after they’ve already fallen by a large amount. Instead, it’s critical to plan appropriately ahead of time. Being diversified, such as in one of the TSP Lifecycle funds, is one of the simplest ways to reduce risk and manage volatility.