Will the Fed Play the Hero or the Heel?

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Defining the Arc of the Markets—Michelle Knight, President and Chief Economist of Ropes Wealth Advisors

Please note, this article was originally published by Ropes Wealth Advisors (RWA), a subsidiary of Adviser Investments, before the markets closed on Friday, August 25, 2023. Click here for more on the partnership between our two firms and here to read more about Michelle. 

One thing you might not guess about me is that I have been to Friday Night Smackdown. Twice. It’s not that I am a professional wrestling fan. I just have three sons whom I adore who enjoyed the spectacle and storylines of the WWE so there I was, ringside, while John Cena took on Roman Reigns as the main event. For those of you who don’t follow the sport, there is a character arc to each wrestler, where they often go from hero to heel and back again. In between the body slams and broken tables, they build a persona based on extremes, impossibly heroic or ceaselessly evil. They shape shift between those extremes from season to season, and their fans accept it (and even revel in it) as they wonder what will happen next.

So, too, investors are wondering what will happen next with markets and economy, and whether the Fed will play the role of hero or heel in this upcoming season. By the sound of the rhetoric coming from the central bank’s economic symposium at Jackson Hole, Wyoming, it would seem the Fed is ready to play the heel.

In today’s speech, Fed Chair Jerome Powell reiterated the need for further action in order to achieve the Committee’s inflation target. “Although inflation has moved down from its peak—a welcome development—it remains too high,” Powell said. “We are prepared to raise rates further if appropriate and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.” He did concede the challenge of threading the needle on this work, but nonetheless emphasized utmost vigilance.

With that, investors are becoming increasingly convinced rates can—and will—remain elevated for some time. This realization, coupled with the wobbly economic data that has begun to emerge, has investors on edge. In this week’s news, the National Association of Realtors said existing home sales slipped 2.2% in July to a six-month-low annualized rate of 4.07 million units. Sales were down 16.6% from the same month last year. Meanwhile, the Census Bureau reported durable goods orders fell a larger-than-expected 5.2% in July. The decline partly reflected weaker orders for aircraft and related parts. Economists track durable goods spending for a sense of consumer and business appetite for big-ticket items built to last at least three years, like washing machines, computer equipment and vehicles. On the flip side, claims for first-time unemployment benefits fell by 10,000 to 230,000 for the week ended August 19. Therefore, the labor market remains tight despite the Fed’s historically rapid interest-rate increases over the past year and a half. And yet, multiple reports from retailers this week, including the likes of Macy’s, Dick’s Sporting Goods and Home Depot, suggest softening consumer demand as savings run low and rising interest rates and student loan repayments stifle spending.

With manufacturing contracting, the housing market slowing and consumer spending sputtering, growth is likely to slow. To further complicate the outlook, if inflation remains elevated into next year and beyond, the Fed is unlikely to materially reverse course, keeping pressure on shorter-term rates relative to decelerating longer-term costs, keeping the yield curve significantly inverted. An outright recession and market drawdown may therefore not be avoided unless a new hero comes to the rescue.

Technology stocks are trying to play that role, none more so than Nvidia, the AI chipmaker that reported a more-than ninefold surge in quarterly income and a doubling in revenue in its latest earnings release. Nvidia’s shares have more than tripled this year with growing expectations that demand for the company’s advanced chips will increase to serve the market for so-called generative AI applications like ChatGPT.

Markets have given back a bit of their year-to-date gains in August despite some heroic earnings releases and may be ripe for more short-term angst in the absence of a positive catalyst. That might come in the form of stabilizing or even falling interest rates, but for now, we continue to recommend diversification and periodic rebalancing to lessen risks while maintaining price and quality discipline on stocks. Bonds are more and more interesting in this new world of higher-for-longer interest rates, and given the sharp move higher in intermediate bond yields, it could be time to extend maturity structure beyond just the front-end.

Finally, speaking of heels, following the totally not suspicious crash of a plane in which Yevgeny Prigozhin was traveling, President Vladimir Putin remains the unchallengeable leader of Russia. As a reminder, Prigozhin led his Wagner mercenary group on a march to Moscow in June in what many saw as a challenge to Putin’s leadership. Many of Russia’s elite had been surprised that Putin didn’t “punish” Prigozhin following his rebellion. The cause of the crash has not been fully investigated, but it does follow a pattern of anyone challenging Putin winding up dead.

The Value of Bonds

As Michelle noted above, bonds have become more attractive as rising interest rates have resulted in higher yields. Given Chair Powell’s comments and with inflation remaining above the policymakers’ target, higher interest rates are likely to be a theme through year-end and beyond.

While yields on shorter-term bonds have gotten most of the attention as they closely track the fed funds rate and have risen north of 5%, longer-term bonds have seen their yields rise too, finally exceeding the rate of inflation this year. The 10-year Treasury note’s yield eclipsed 4.3% earlier this month, its highest level since 2007.

Even though the yield curve is still inverted (when short-term bonds yield more than long-term bonds), this flattening at the longer end of the curve presents opportunities for income-focused investors.

You might hear that longer-term bonds are flirting with another year of negative calendar returns. But with yields moving higher, the potential to lock in a more generous stream of income can pay dividends over time.

What about bond funds? A bond fund gives you both capital return and income return—added together, there’s your total return. The chart below shows how a bond fund’s income return generally keeps the total return in positive territory, despite swings in capital returns from year to year. The stabilizing influence of bond funds’ income returns makes them key components of a diversified portfolio.

But what if the Fed hikes interest rates again or keeps them elevated for an extended period?

In the chart below, we’ve calculated rolling six-month returns for bonds from 1987 through July 2023 (using Vanguard’s Total Bond Market Index as a proxy for the overall market) and mapped those returns to periods of rising rates, falling rates and flat rates.

Over the last 35-plus years, the bond market has generated outsized gains when rates are falling and small gains during rising-rate periods. And when rates are flat, the average six-month return is essentially equal to their return over all periods. So based on the historical data, the possibility of rising rates or the Federal Reserve keeping rates steady is not a reason to avoid the bond market.

If you have any questions about how your portfolio’s allocation aligns with your big-picture financial planning goals, please contact your advisor.

How Do Interest Rates Impact Your Estate Plan?

Just as rising interest rates influence your investment portfolio, they also factor into estate planning. For high-net-worth families concerned about estate taxes, irrevocable trusts can provide some relief. Depending on the type of trust, however, its efficacy can be significantly affected by the applicable federal rate (AFR) set by the IRS, which is in turn dependent on the Federal Reserve’s interest rate policy.

It can get confusing. Let us help provide some clarity, starting with a review of how you might use different trusts and the impact of interest rates on each type.

Grantor Retained Annuity Trusts (GRATs)

Grantor retained annuity trusts have several attractive features, including the ability to:

• Direct assets into an irrevocable trust and freeze their value
• Pass additional growth of assets in the trust on to your beneficiaries
• Reduce estate taxes

A GRAT’s effectiveness depends on interest rates. If the assets transferred to the GRAT grow at a rate that exceeds the AFR, the excess appreciation is transferred to the remainder beneficiaries (like your children) gift-tax-free.

In the past, a GRAT had to beat a much lower interest-rate hurdle to allow additional estate growth to be shifted to beneficiaries. But with the AFR currently ranging from 4% to 5%, the assets in the trust have a higher threshold to beat before those gains can be passed on.

When rates were low, one strategy would be to seed multiple GRATs with high-growth-potential assets in the hopes they quickly realized gains. If the asset declined in value, heirs were unaffected, and you could try again with a new GRAT—essentially a trial-and-error approach to giving your heirs the right to risk-free and gift tax-free investment profits.

Now that rates are at generational highs, GRATs may be a less effective option if you’re prioritizing growing assets in the trust.

Qualified Personal Residence Trusts (QPRTs) 

A qualified personal residence trust allows you to:

• Pass a home to the next generation during your lifetime
• Reduce taxes
• Remain in the home for a chosen period of time, after which the residence becomes the property of your appointed beneficiaries.

The initial transfer of the property to the trust is considered a taxable gift. The value of that gift is determined by the value of the grantor’s remainder interest (their right to use and enjoy the residence during the term of the trust).

When interest rates are relatively high, that remainder interest also increases. The result? A lower taxable gift. That makes the QPRT strategy more attractive when rates are elevated.

Charitable Remainder Trusts (CRTs)

It’s a similar story for charitable remainder trusts. A CRT is an irrevocable trust that can help you accomplish several goals at once:

• Reduce your taxable assets
• Create a predefined income stream for yourself or your beneficiaries
• Make a gift to a charitable organization in the future

When you transfer cash or other assets into a CRT, you receive an immediate income tax charitable deduction based on the present value of the portion of the trust that will ultimately go to the named charity.

The value of the remainder that goes to charity is calculated using interest rates when the trust is initially funded. The higher interest rates are, the higher the value of the remainder interest and the greater the immediate tax deduction when funding the trust. That makes it easier for the CRT to pass IRS muster. Additionally, a CRT generates income for the grantor. High interest rates make funding that minimum required payment an easier task.

Intentionally Defective Grantor Trusts (IDGTs)

Intentionally defective grantor trusts (strange name aside) are a popular choice for high-net-worth families. This is because they enable you to:

• Pass income-producing assets to your heirs (via limited partnerships, real estate, S-corporation stock or even a family business)
• Lower the tax burden of the gift
• Use income generated within the trust to cover its required interest payments

The sale of an asset to the IDGT is made in exchange for a promissory note that pays back the grantor over time, followed by a balloon payment of the principal. Meanwhile, the grantor of the trust is required to pay the trust’s interest—this could be covered by income generated by assets within the trust or in gifting the necessary cash to the trust—that’s why income-producing assets work best in IDGTs.

When interest rates were low, the size of required payments stayed down and, in theory, you could fund those interest payments with the business’ profits from within the trust without any additional gifting.

Since interest rates are much higher, new IDGTs will require some extra planning. The grantor must have cash flow to pay the income tax of the trust and inject it with cash (if necessary) to cover the promissory note interest payments.

If the asset placed inside the trust does not appreciate faster than the interest rate applicable to the transaction, you lose the benefit of an IDGT.

Key Takeaways

High-net-worth individuals have many possibilities for transferring assets to the next generation or charity, but they require the help of a professional estate planner. Beyond picking the right trust to reduce your tax burden and meet your overall objectives, you must consider the variables that could impact its effectiveness.

If you are interested in setting up a trust, particularly a CRT or QPRT, this is a good time to explore your options because high interest rates provide a tailwind. If a GRAT or IDGT seems like a better match for your long-term goals, it may be worth setting one up now and then delaying execution until rates fall.

As always, your advisor is standing by to help you create, modify or review your estate plan—please call today if you have any questions.

Adviser Market Update

• In July, job openings in the U.S. dropped to their lowest level since early 2021, but there are still an average of 1.5 positions available for every job seeker. Along with a lower rate of resignations, this may be an early signal that Americans are losing confidence in the job market.
• Speaking of confidence, according to The Conference Board, consumers are feeling less sanguine this month. Rising prices for gasoline and groceries are taking a toll. While this gauge is not flashing red, lower confidence can lead consumers to cut back on spending, which in turn can contribute to slower economic growth.
• Today, the personal consumption expenditures index (the Fed’s preferred inflation gauge) showed that the price of goods and services increased by 0.2% in July and year-over-year inflation ticked up to 3.3% from 3%. This was in line with expectations and supports the Fed’s view that there is more to be done in the fight against inflation.