What Does a Strong Dollar Mean for the U.S. Economy?
In late September 2022, the U.S. dollar hit a 20-year high in an index that measures its value against six major currencies: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc. At the same time, a broader inflation-adjusted index that captures a basket of 26 foreign currencies reached its highest level since 1985. Both indexes eased slightly but remained near their highs in October.1–2
Intuitively, it might seem that a strong dollar is good for the U.S. economy, but the effects are mixed in the context of other domestic and global pressures.
World Standard
The U.S. dollar is the world’s reserve currency. About 40% of global financial transactions are executed in dollars, with or without U.S. involvement.3As such, foreign governments, global financial institutions, and multinational companies all hold dollars, providing a level of demand regardless of other forces.
Demand for the dollar tends to increase during difficult times as investors seek stability and security. Despite high inflation and recession predictions, the U.S. economy remains the strongest in the world.4 Other countries are battling inflation, too, and the strong dollar is making their battles more difficult. The United States recovered more quickly from the pandemic recession, putting it in a better position to weather inflationary pressures.
The Federal Reserve’s aggressive policy to combat inflation by raising interest rates has driven demand for the dollar even higher because of the appealing rates on dollar-denominated assets such as U.S. Treasury securities. Some other central banks have begun to raise rates as well — to fight inflation and offer better yields on their own securities. But the strength of the U.S. economy allows the Fed to push rates higher and faster, which is likely to maintain the dollar’s advantage for some time.
Exports and Imports
The strong dollar makes imported goods cheaper and exported goods more expensive. Cheaper imports are generally good for consumers and for companies that use foreign-manufactured supplies, but they can undercut domestic sales by U.S. producers.
At the same time, the strong dollar effectively raises prices for goods that U.S. companies sell in foreign markets, making it more difficult to compete and reducing the value of foreign purchases. For example, a U.S. company that sells 10,000 euros worth of goods to a foreign buyer would receive less revenue when a euro buys fewer dollars. Some experts are concerned that the strong dollar will dampen the post-pandemic rebound in U.S. manufacturing.5 More broadly, the ballooning trade deficit cuts into U.S. gross domestic product (GDP), which includes imports as a negative input and exports as a positive input.
Overseas Exposure
Generally, large multinational companies have the most exposure to risk from currency imbalances, and the stock market has shown signs of a shift from large companies — which have dominated the market since before the pandemic — to smaller companies that may be more nimble and less dependent on overseas sales. The S&P SmallCap 600 index has outperformed the S&P 500 index through late October; if the trend continues through the end of the year, it would be the first time since 2016 that small caps have eclipsed large caps.6 The S&P MidCap 400 index has done even better. In the current bear market, however, better performance means lower losses; all three indexes have had double-digit losses through October 2022.7
Global Pain
A weak currency can be a boon for a country by making its exports more competitive. But with the world economy weakening, other countries are not reaping those benefits, while paying more on debt and imported essentials such as food and fuel that are traded in dollars. The Fed is focused on domestic concerns, but it is effectively exporting inflation while trying to control it at home, and global economic pain could ultimately spread to the U.S. economy.8
Slowing the Dollar
In the near term, the Fed’s aggressive rate hikes may reduce domestic demand for foreign goods, reducing the trade deficit and weakening the dollar. The advance Q3 2022 GDP estimate showed the trade gap closing, but it’s unclear if the trend will last.9
In the longer term, as inflation eases in the United States, the Fed will likely take its foot off the gas pedal and ultimately bring rates down. This would allow other central banks to catch up if they choose to do so and would make foreign currencies and securities more appealing. Lower oil prices (denominated in dollars) and/or any reduction in world tensions — such as a slowdown in the Russia-Ukraine war — might also help reduce demand for dollars.
The dynamics of these factors are complex, and it may take time for any of them to unfold. In the meantime, the strong dollar is a sign of U.S. economic strength, and it would not be wise to place too much emphasis on it for long-term investment decisions. However, this could be a great time for an overseas vacation.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid.
All investments are subject to market volatility and loss of principal. Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, and economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost. The value of a foreign investment, measured in U.S. dollars, could decrease because of unfavorable changes in currency exchange rates.
The S&P 500 index is an unmanaged group of securities that is considered to be representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results. Actual results will vary.
1) MarketWatch, October 19, 2022 (U.S. Dollar index)
2) Federal Reserve, 2022 (Real Broad Dollar index)
3, 8) The New York Times, September 26, 2022
4, 6) The Wall Street Journal, October 17, 2022
5) The Wall Street Journal, October 9, 2022
7) S&P Dow Jones Indices, 2022
9) U.S. Bureau of Economic Analysis, 2022
Highlights of the Inflation Reduction Act High
The Inflation Reduction Act, signed into law on August 16, 2022, includes healthcare and energy-related provisions, a new corporate alternative minimum tax, and an excise tax on certain corporate stock buybacks. Additional funding is also provided to the IRS. Some significant provisions in the Act are discussed below.
Medicare
The legislation authorizes the Department of Health and Human Services to negotiate Medicare prices for certain high-priced, single-source drugs. However, only 10 of the most expensive drugs will be chosen initially, and the negotiated prices will not take effect until 2026. For each of the following years, more negotiated drugs will be added.
Starting in 2025, a $2,000 annual cap (adjusted for inflation) will apply to out-of-pocket costs for Medicare Part D prescription drugs.
Deductibles will not apply to covered insulin products under Medicare Part D or under Part B for insulin furnished through durable medical equipment until 2023, . Also, the applicable copayment amount for covered insulin products will be capped at $35 for a one-month supply.
Health Insurance
Starting in 2023, a high-deductible health plan can provide that the deductible does not apply to selected insulin products.
Affordable Care Act subsidies (scheduled to expire at the end of 2022) that improved affordability and reduced health insurance premiums have been extended through 2025. Indexing of percentage contribution rates used in determining a taxpayer’s required share of premiums is delayed until after 2025, preventing more significant premium increases. Additionally, those with household incomes higher than 400% of the federal poverty line remain eligible for the premium tax credit through 2025.
Energy-Related Tax Credits
Many current energy-related tax credits have been modified and extended, and a few new credits have been added. Many of the credits are available to businesses, and others are available to individuals. The following two credits are substantial revisions and extensions of an existing tax credit for electric vehicles.
Starting in 2023, a tax credit of up to $7,500 is available for the purchase of new clean electric vehicles meeting certain requirements. The credit is not available for vehicles with a manufacturer’s suggested retail price higher than $80,000 for sports utility vehicles and pickups, $55,000 for other vehicles. The credit is not available if the modified adjusted gross income (MAGI) of the purchaser exceeds $150,000 ($300,000 for joint filers and surviving spouses, $225,000 for heads of household). Starting in 2024, an individual can elect to transfer the credit to the dealer as payment for the vehicle.
Similarly, a tax credit of up to $4,000 is available for the purchase of certain previously owned clean electric vehicles from a dealer. The credit is not available for vehicles with a sales price exceeding $25,000. The credit is not available if the purchaser’s MAGI exceed $75,000 ($150,000 for joint filers and surviving spouses, $75,000 for heads of household). An individual can elect to transfer the credit to the dealer as payment for the vehicle.
Corporate Alternative Minimum Tax
For taxable years beginning after December 31, 2022, a new 15% alternative minimum tax (AMT) will apply to corporations (other than an S corporation, regulated investment company, or a real estate investment trust) with an average annual adjusted financial statement income more than $1 billion.
Adjusted financial statement income means the net income or loss of the taxpayer set forth in the corporation’s financial statement (often referred to as book income), with certain adjustments. If regular tax exceeds the tentative AMT, the excess amount can be carried forward as a credit against the AMT in future years.
Excise Tax on Repurchase of Stock
For corporate stock repurchases after December 31, 2022, a new 1% excise tax will be imposed on the value of a covered corporation’s stock repurchases during the taxable year.
A covered corporation means any domestic corporation whose stock is traded on an established securities market. However, the excise tax does not apply: (1) to a repurchase that is part of a nontaxable reorganization, (2) with respect to certain contributions of stock to an employer-sponsored retirement plan or employee stock ownership plan, (3) if the total value of stock repurchased during the year does not exceed $1 million, (4) to a repurchase by a securities dealer in the ordinary course of business, (5) to repurchases by a regulated investment company or a real estate investment trust, or (6) to the extent the repurchase is treated as a dividend for income tax purposes.
Increased Funding for the IRS
Substantial additional funds are provided to the IRS to help fund operations and business systems modernization and to improve enforcement of tax laws.
Are we in a Recession?
A common definition is that a recession occurs when there are two consecutive quarters of declining in gross domestic product (GDP). The GDP is the total of all the goods and services produced in a country. The National Bureau of Economic Research (NBER) determines when the United States (U.S.) is in a recession. It is a private nonpartisan organization that began dating business cycles in 1929. The committee, which was formed in 1978, includes eight economists who specialize in macroeconomic and business cycle research.1 The NBER defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” The committee looks at the big picture and makes exceptions as appropriate. For example, the economic decline of March and April 2020 was so extreme that it was declared a recession even though it lasted only two months.2
The committee studies a range of monthly economic data, with special emphasis on six indicators: personal income, consumer spending, wholesale-retail sales, industrial production, and two measures of employment. Because official data is typically reported with a delay of a month or two — and patterns may be clear only in hindsight — it generally takes some time before the committee can identify a peak or trough. Some short recessions (including the 2020 downturn) were over by the time they were officially announced.3
Public Opinion
Consumer sentiment is a significant factor. It is a powerful factor in consumer spending. Consumer spending is a substantial part of GDP. An early July poll, 58% of Americans said they thought the U.S. economy was in a recession, up from 53% in June and 48% in May.4 Yet many economic indicators, notably employment, remain strong. The current situation is unusual, and there is little consensus among economists as to whether a recession has begun or may be coming soon.5
GDP
Real (inflation-adjusted) GDP dropped at an annual rate of 1.6% in the first quarter of 2022 and by 0.9% in the second quarter.6
Since 1948, the U.S. economy has never experienced two consecutive quarters of negative GDP growth without a recession being declared. However, the current situation could be an exception, due to the strong employment market and some anomalies in the GDP data.7
Negative first-quarter GDP was largely due to a record U.S. trade deficit, as businesses and consumers bought more imported goods to satisfy demand. This was a sign of economic strength rather than weakness. Consumer spending and business investment — the two most important components of GDP — both increased for the quarter.8
Initial second-quarter GDP data showed a strong positive trade balance but slower growth in consumer spending, with an increase in spending on services and a decrease in spending on goods. The biggest negative factors were a slowdown in residential construction and a substantial cutback in growth of business inventories.9 Although inventory reductions can precede a recession, it’s too early to tell whether they signal trouble or are simply a return to more appropriate levels.10 Economists may not know whether the economy is contracting until there is additional monthly data.7
Employment
Economic data has been mixed recently. Consumer spending declined in May when adjusted for inflation, but bounced back in June.11 Retail sales were strong in June, but manufacturing output dropped for a second month.12 The strongest and most consistent data has been employment. The economy added 372,000 jobs in June, the third consecutive month of gains in that range. Total nonfarm employment is now just 0.3% below the pre-pandemic level, and private-sector employment is actually higher (offset by losses in government employment).13
The unemployment rate has been 3.6% for four straight months, essentially the same as before the pandemic (3.5%), which was the lowest rate since 1969.9 Initial unemployment claims ticked up slightly in mid-July but remained near historic lows.14 In the 12 recessions since World War II, the unemployment rate has always risen, with a median increase of 3.5 percentage points.16
With employment at such high levels, it may be questionable to characterize the current economic situation as a recession. However, the employment market could change, and recessions can be driven by fear as well as by fundamental economic weakness.
Inflation
The fear factor is inflation which ran at an annual rate of 9.1% in June, the highest since 1981.17 Wages have increased, but not enough to make up for the erosion of spending power, making many consumers more cautious despite the strong job market.18 If consumer spending slows significantly, a recession is certainly possible, even if it is not already under way. Inflation has forced the Federal Reserve to raise interest rates aggressively, with a 0.50% increase in the benchmark federal funds rate in May, followed by 0.75% increases in June and July.18 It takes time for the effect of higher rates to filter through the economy, and it remains to be seen whether there will be a “soft landing” or a more jarring stop that throws the economy into a recession.
Among the factors driving inflation are: Covid-19, Russian Invasion of Ukraine, supply chain disruptions, CARES ACTs 1, 2 and 3, fewer homes for sale than buyers, limited supply of semiconductors .
Unfortunately, no one knows the future, and economic forecasts vary significantly. Forecast range from remote chance of a recession to an imminent downturn with a moderate recession in 2023.19 If that turns out to be the case, or if a recession arrives sooner, it’s important to remember that recessions are generally short-lived, lasting an average of just 10 months since World War II. By contrast, economic expansions have lasted 64 months.20 To put it simply: The good times typically last longer than the bad.
Projections are based on current conditions, are subject to change, and may not happen.
1-3) National Bureau of Economic Research, 2021
4) Investor’s Business Daily, July 12, 2022
5) The Wall Street Journal, July 17, 2022
6) U.S. Bureau of Labor Statistics, 2022
7-8) MarketWatch, July 5, 2022
6,9,11,21) U.S. Bureau of Economic Analysis, 2022
10) The Wall Street Journal, July 28, 2022
12) Reuters, July 15, 2022
13–14, 17–18) U.S. Bureau of Labor Statistics, 2022
15) The Wall Street Journal, July 14, 2022
16) The Wall Street Journal, July 4, 2022
19) Federal Reserve, 2022
20) The New York Times, July 1, 2022
Good and Bad News about Social Security
With approximately 94% of American workers covered by Social Security and 65 million people currently receiving benefits, keeping Social Security healthy is a major concern.1 Social Security is financed primarily through payroll taxes. Unless Congress act benefits may eventually be reduced. Trustees of the Social Security Trust Funds release a detailed report to Congress in June. The good news was that the effects of the pandemic were not as significant as projected a year ago.
Mixed news for Social Security
Social Security program consists of two programs, the Old-Age and Survivors Insurance (OASI) program and Disability Insurance (OASDI). Each program has its own financial account (Trust Fund). Payroll taxes collected are deposited in the applicable Trust Fund. OASI provide benefits to retired workers, their families, and survivors of workers. D provides benefits to disabled workers and their families. Funding is also provided by other income (reimbursements from the General Fund of the U.S. Treasury and income tax revenue from benefit taxation).
Social security is required to invest funds collected in special government-guaranteed Treasury bonds that earn interest. These funds are now being used to pay benefits more than the payroll tax collected. Payroll taxes are not sufficient to pay current benefits. Changes in our demographics are a significant reason for the deficiency.
A recent report by the Trustees estimate that the funds will not be able to fund full retirement and survivor benefits. Benefit would then be reduced to 77% of scheduled OASI benefits, declining to 72% through 2096, the end of the 75-year, long-range projection period.
The Trustees report, estimate the combined reserves (OASDI) will be able to pay scheduled benefits until 2035. Benefit would then be reduced to 80% of scheduled benefits, declining to 74% by 2096. OASI and DI Trust Funds are separate, and generally one program’s taxes and reserves cannot be used to fund the other program. However, this could be changed by Congress, and combining these trust funds in the report is a way to illustrate the financial outlook for Social Security as a whole.
The above is based on current conditions and likely future demographic, economic, and program-specific conditions. Future events including the impact of the pandemic may results in changes not reflected in the Trustee’s estimates.
Some changes can be made to improve the situation
The Trustees continue to urge Congress to address the financial challenges. The sooner Congress acts the less harsh the changes will be. Some of the options that have been suggested including the following:
- Raising the current Social Security payroll tax rate. Increasing the payroll tax to 15.64% from 12.4% would correct the situation
- Raising or eliminating the ceiling on wages subject to Social Security payroll taxes ($147,000 in 2022).
- Raising the full retirement age from 67 (for anyone born in 1960 or later).
- Raising the early retirement age from 62.
- Reducing future benefits by about 20.3% for all current and future beneficiaries, or by about 24.1% if reductions were applied only to those who initially become eligible in 2022 or later.
- Changing the benefit formula that is used to calculate benefits.
- Calculating the annual cost-of-living adjustment (COLA) for benefits.
A comprehensive list of potential solutions can be found at https://www.ssa.gov/OACT/solvency/provisions/.
1) Social Security Administration, 2022
IRS Releases 2023 Key Numbers for Health Savings Accounts
The IRS has released the 2023 contribution limits for health savings accounts (HSAs), as well as the 2023 minimum deductible and maximum out-of-pocket amounts for high-deductible health plans (HDHPs). An HSA is a tax-advantaged account that’s paired with an HDHP. An HSA offers several valuable tax benefits:
You may be able to make pre-tax contributions via payroll deduction through your employer, reducing your current income tax.
If you make contributions on your own using after-tax dollars, they’re deductible from your federal income tax (and perhaps from your state income tax) whether you itemize or not.
Contributions to your HSA, and any interest or earnings, grow tax deferred.
Contributions and any earnings you withdraw will be tax-free if used to pay qualified medical expenses.
Key tax numbers for 2022 and 2023.
Health Savings Accounts
Annual contribution limit 2022 2023
Self-only coverage $3,650 $3,850
Family coverage $7,300 $7,750
High-deductible health plan: self-only coverage 2022 2023
Annual deductible: minimum $1,400 $1,500
Annual out-of-pocket expenses required to be paid
(other than for premiums) can’t exceed $7,050 $7,500
High-deductible health plan: family coverage 2022 2023
Annual deductible: minimum $2,800 $3,000
Annual out-of-pocket expenses required to be paid (other than for premiums) can’t exceed
$14,100 $15,000
Catch-up contributions
Annual catch-up contribution limit for individuals age 55 or older $1,000 2022 and 2023
The IRS has released the 2023 key tax numbers for health savings accounts (HSAs) and high-deductible health plans (HDHPs).
Rising Rates Add to Housing Dilemmas
Home buyers braving the hot U.S. housing market have run headlong into a striking transition. The average interest rate for a 30-year fixed mortgage jumped from around 3.2% at the beginning of 2022 to 5.3% in mid-May, the highest level since 2009. This rise was sparked by the Federal Reserve’s commitment to raise the federal funds rate — a key benchmark for short-term interest rates — to help control the highest inflation in decades.1
Although mortgage rates are not directly tied to the federal funds rate, all borrowing costs are influenced by the Fed’s monetary policies. Mortgage rates tend to track changes in the 10-year Treasury yield, which is sensitive to changes in the funds rate and fluctuates based on the bond market’s longer-term expectations for economic growth and inflation.
Housing Costs Are Soaring
For nearly two years now, buyers have faced an intensely competitive housing market characterized by historically low inventory, bidding wars, and escalating prices. The national median price of existing homes rose 14.8% over the year ending April 2022 to reach $391,200. Home prices are rising in every region, and 70% of the nation’s 185 metro areas experienced double-digit annual increases in the first quarter. In a notable shift, price gains in affordable small- and mid-size cities outpaced gains in more expensive urban markets, as many home buyers seized the opportunity to work remotely.2
Home prices and market conditions can vary widely by region and even by neighborhood. April median prices in the 10 most expensive cities ranged from $662,000 in Denver to $1,875,000 in San Jose. Half of the nation’s 10 priciest markets are in California, a state with a particularly severe and longstanding housing shortage.3
Rents have also been rising. In April 2022, the median rent for 0- to 2-bedroom properties in the 50 largest U.S. metro areas reached $1,827, a year-over-year increase of 16.7%. Spikes were more dramatic in Sun Belt cities such as Miami (51.6%), San Diego (25.6%), and Austin (24.7%).4
In this environment, prospective home buyers, renters who must renew a lease, or anyone looking for a different place to live could find themselves in a challenging situation.
Affordability Is Waning
The combination of rising mortgage rates and home prices has taken a serious toll on affordability. A borrower with a $300,000 mortgage would pay $1,666 per month at a 5.3% rate versus $1,297 at a 3.2% rate, the prevailing rate earlier this year. Affordability is an even bigger issue in high-cost areas and for first-time buyers who haven’t benefited from gains in home equity.
Borrowers who started a home search and were pre-qualified by a lender before rates spiked may not be approved for the mortgages they initially sought. Consequently, demand for adjustable-rate mortgages (ARMs) that offer lower rates has surged in recent months.5 A lower monthly payment makes it possible to qualify for a larger mortgage, so borrowers who expect to move at some point may be comfortable with an ARM that has a fixed rate for the first three, five, seven, or 10 years of the 30-year term before it adjusts to prevailing rates.
Some buyers will change their expectations and settle for a less-expensive home. But others may give up the search if they are not satisfied with the homes they can afford, especially if they are priced out of their favorite neighborhoods. Many entry-level buyers could be forced out of the market entirely, at least for the time being.
Buyers of new homes may be subject to substantial interest-rate risk because purchase contracts are often signed many months before their homes will be completed. With their deposits at stake, buyers might consider paying the extra cost to extend rate locks for six, nine, or even 12 months.
Higher borrowing costs are likely to reduce demand for homes enough to slow price growth, and prices might retreat in some overheated markets. Even so, most economists don’t expect home prices to collapse because market fundamentals are otherwise relatively strong. Inventory levels are still extremely low, and lenders have generally been conservative, so most homeowners who bought in recent years can afford their mortgages.6 Interest rates don’t impact cash buyers, such as downsizing retirees and investors, who account for about 26% of transactions.7 And assuming the economy and employment hold up, there should be plenty of demand from millennials in their peak home buying years.8
Tips for Bewildered First-Time Buyers
Paying rent indefinitely may do little to improve your financial future, but if you are ready to commit to a mortgage, buying a home could stabilize your housing costs for as long as the payment is fixed. You can also build equity in the property as your loan balance is paid off over time — more so if the value appreciates.
No one knows for sure where mortgage rates are headed or what will happen next in the housing market. So how can you decide whether it makes financial sense to purchase a home? As always, the answer depends on where you want to live, your lifestyle preferences, and your finances.
Here are three ways to start preparing for the home buying process.
Become a better borrower. Before you apply for a mortgage, order a copy of your credit report to check for errors and clean up any inaccuracies. Having a higher credit score could earn you a lower interest rate.
Save up for a down payment. Buyers must typically invest 20% of the purchase price for conventional mortgages, but some loan programs allow smaller down payments of 5% to 10%. If parents or other family members offer to “gift” cash for a down payment, lenders may ask for a letter to document the source of funds. There may also be local programs that provide down-payment assistance for buyers who meet income requirements and take classes on home ownership.
Find out how much you can afford to spend. Start with online calculators that take your income, debt, and expenses into account. A mortgage provider can help determine how much you may qualify to borrow. It can take three to five years to recoup real estate transaction costs, so be sure to consider the stability of your employment situation and your income.
1) Bloomberg, May 12, and May 19, 2022
2-3, 7) National Association of Realtors, 2022
4) Realtor.com, 2022
5) The Wall Street Journal, May 5, 2022
6) NPR, May 12, 2022
8) The Wall Street Journal, December 14, 2021
Federal Student Loan Repayments Are Postponed Again
The U.S. Department of Education announced the sixth extension for federal student loan repayment, interest, and collections, through August 31, 2022.1 The prior postponement, the fifth, was to end April 30, 2022. The original extension was in March 2020 at the start of the pandemic.
Education Secretary Miguel Cardona stated: “This additional extension will allow borrowers to gain more financial security as the economy continues to improve and as the nation continues to recover from the COVID-19 pandemic.2
A “fresh start”
The Department of Education noted that it will give all federal student loan borrowers a “fresh start” by allowing them to enter repayment in good standing, even those individuals whose loans have been delinquent or in default. More information about loan rehabilitation will be coming from the Department in the weeks ahead.
The Department’s press release stated: “During the extension, the Department will continue to assess the financial impacts of the pandemic on student loan borrowers and to prepare to transition borrowers smoothly back into repayment. This includes allowing all borrowers with paused loans to receive a ‘fresh start’ on repayment by eliminating the impact of delinquency and default and allowing them to reenter repayment in good standing.”3
What should borrowers do between now and September?
Approximately 41 million Americans have federal student loans.4 There are a number of things borrowers can do between now and September 2022.
• Seek to build up financial reserves during the next few months to be ready to start repayment in September.
• Continue making student loan payments during the pause (the full amount of the payment will be applied to principal). Interest doesn’t accrue during the pause. Borrowers who continue making payments during this time may be able to save money in the long term, because when the pause ends, interest will be accruing on a smaller principal balance.
• Apply for the federal Public Service Loan Forgiveness (PSLF) program if they are working in public service and have not yet applied.
• Visit the federal student aid website, studentaid.gov, to learn more about PSLF and loan repayment options, including income-based options.
• Pay attention to the news. There has been increased political pressure on the current administration to enact some type of student loan cancellation, ranging from $10,000 per borrower to full cancellation. There are no guarantees, however. So, it wouldn’t be a good idea for borrowers to put all their eggs in this basket.
1-3) U.S. Department of Education, 2022
4) The Washington Post, April 6, 2022
Managing Bond Risks When Interest Rates Rise
After dropping the benchmark federal funds rate to a rock-bottom range of 0%–0.25% early in the pandemic, the Federal Open Market Committee has begun raising the rate toward more typical historical levels in response to high inflation. At its March 2022 meeting, the Committee raised the funds rate to 0.25%–0.50% and projected the equivalent of six more quarter-percentage-point increases in 2022 and three or four more in 2023.1
Raising the federal funds rate places upward pressure on a wide range of interest rates, including the cost of borrowing through bond issues. Regardless of the rate environment, however, bonds are a mainstay for investors who want to generate income or dampen the effects of stock market volatility on their portfolios. You may have questions about how higher rates could affect your fixed-income investments and what you can do to help mitigate the effect in your portfolio.
Rate sensitivity
When interest rates rise, the value of existing bonds typically falls, because investors would prefer to buy new bonds with higher yields. In a rising rate environment, investors may be hesitant to tie up funds for a lengthy period, so bonds with longer maturity dates are generally more sensitive to rate changes than shorter-dated bonds. Thus, one way to address interest-rate sensitivity in your portfolio is to hold short- and medium-term bonds. However, keep in mind that although these bonds may be less sensitive to rate changes, they will generally offer a lower yield than longer-term bonds.
A more specific measure of interest-rate sensitivity is called duration. A bond’s duration is derived from a complex calculation that includes the maturity date, the present value of principal and interest to be received in the future, and other factors. To estimate the impact of a rate change on a bond investment, multiply the duration by the expected percentage change in interest rates. For example, if interest rates rise by 1%, a bond or bond fund with a three-year duration might be expected to lose roughly 3% in value; one with a seven-year duration might fall by about 7%. Your investment professional or brokerage firm can provide information about the duration of your bond investments.
If two bonds have the same maturity, the bond with the higher yield will typically have a shorter duration. For this reason, U.S. Treasuries tend to be more rate sensitive than corporate bonds of similar maturities. Treasury securities, which are backed by the federal government as to the timely payment of principal and interest, are considered lower risk and thus can pay lower rates of interest than corporate bonds. A five-year Treasury bond has a duration of less than five years, reflecting income payments received prior to maturity. However, a five-year corporate bond with a higher yield has an even shorter duration.
When a bond is held to maturity, the bond owner would receive the face value and interest, unless the issuer defaults. However, bonds redeemed prior to maturity may be worth more or less than their original value. Thus, rising interest rates should not affect the return on a bond you hold to maturity, but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.
Bond ladders
Owning a diversified mix of bond types and maturities can help reduce the level of risk in the fixed-income portion of your portfolio. One structured way to take this risk management approach is to construct a bond ladder, a portfolio of bonds with maturities that are spaced at regular intervals over a certain number of years. For example, a five-year ladder might have 20% of the bonds mature each year.
Bond ladders may vary in size and structure, and could include several types of bonds depending on an investor’s time horizon, risk tolerance, and goals. As bonds in the lowest rung of the ladder mature, the funds are often reinvested at the long end of the ladder. By doing so, investors may be able to increase their cash flow by capturing higher yields on new issues. A ladder might also be part of a withdrawal strategy in which the returned principal from maturing bonds provides retirement income.
In the current situation, with rates projected to rise over a two- to three-year period, it might make sense to create a short bond ladder now and a longer ladder when rates appear to have stabilized. Keep in mind that the anticipated path of the federal funds rate is only a projection, based on current conditions, and may not happen. The actual direction of interest rates might change.
Laddering ETFs and UITs
Building a ladder with individual bonds provides certainty if the bonds are held to maturity, but it can be expensive. Individual bonds typically require a minimum purchase of at least $5,000 in face value, so creating a diversified bond ladder might require a sizable investment. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.
A similar approach involves laddering bond exchange-traded funds (ETFs) that have defined maturity dates. These funds, typically called target-maturity funds, generally hold many bonds that mature in the same year the ETF will liquidate and return assets to shareholders. Target maturity ETFs may enhance diversification and provide liquidity, but unlike individual bonds, the income payments and final distribution rate are not fully predictable.
Another option is to purchase unit investment trusts (UITs) with staggered termination dates. Bond-based UITs typically hold a varied portfolio of bonds with maturity dates that coincide with the trust termination date, at which point you could reinvest the proceeds as you wish. The UIT sponsor may offer investors the opportunity to roll over the proceeds to a new UIT, which typically incurs an additional sales charge.
Bond funds
Bond funds — mutual funds and ETFs composed mostly of bonds and other debt instruments — are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond prices due to rising rates can adversely affect a bond fund’s performance. Because longer-term bonds are generally more sensitive to rising rates, funds that hold short- or medium-term bonds may be more stable as rates increase.
Bond funds do not have set maturity dates (except for the target maturity ETFs discussed above), because they typically hold bonds with varying maturities, and they can buy and sell bonds before they mature. So, you might consider the fund’s duration, which considers the durations of the underlying bonds. The longer the duration, the more sensitive a fund is to changes in interest rates. You can usually find duration with other information about a bond fund. Although helpful as a general guideline, duration is best used when comparing funds with similar types of underlying bonds.
A fund’s sensitivity to interest rates is only one aspect of its value — fund performance can be driven by a variety of dynamics in the market and the broader economy. Moreover, as underlying bonds mature and are replaced by higher-yielding bonds in a rising interest rate environment, the fund’s yield and/or share value could potentially increase over the long term. Even in the short term, interest paid by the fund could help moderate any losses in share value.
It’s also important to remember that fund managers might respond differently if falling bond prices adversely affect a fund’s performance. Some might try to preserve the fund’s asset value at the expense of its yield by reducing interest payments. Others might emphasize preserving a fund’s yield at the expense of its asset value by investing in bonds of longer duration or lower credit quality that pay higher interest but carry greater risk. Information on a fund’s management, objectives, and flexibility in meeting those objectives is spelled out in the prospectus and may be available with other fund information online.
The return and principal value of individual bonds, UIT units, and mutual fund and ETF shares fluctuate with changes in market conditions. Fund shares and UIT units, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. ETFs typically have lower expense ratios than mutual funds, but you may pay a brokerage commission whenever you buy or sell ETFs, so your overall costs could be higher, especially if you trade frequently. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares. UITs may carry additional risks, including the potential for a downturn in the financial condition of the issuers of the underlying securities. There may be tax consequences associated with the termination of the UIT and rolling over an investment into a successive UIT. There is no assurance that collaborating with a financial professional will improve investment results.
1) Federal Reserve, March 16, 2022
2021 Federal Income Tax Returns are Due April 18, 2022 For Most Individuals
If you live in Maine or Massachusetts the due date is April 19, 2022.
You can extend the filing date.
You can file for an extension by filing IRS Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return by the April due date. The extension gives you an additional six months (until October 17, 2022) to file your federal income tax return. You can also file for an automatic six-month extension electronically (details on how to do so can be found in the Form 4868 instructions). There may be penalties for failing to file or for filing late.
Note: Special rules apply if you’re living outside the country, or serving in the military outside the country, on the regular due date of your federal income tax return.
Include a payment if possible.
File the return, and pay as much as you can afford if you absolutely cannot pay what you owe. You’ll owe interest and possibly penalties on the unpaid tax. You will limit the penalties assessed by filing your return on time, and you may be able to work with the IRS to pay the unpaid balance (options available may include the ability to enter into an installment agreement).
It’s important to understand that filing for an automatic extension to file your return does not provide any additional time to pay your tax. When you file for an extension, you must estimate the amount of tax you will owe. Paying the full amount by the April filing due date will reduce interest and penalties based on the amount not paid. IRS may void the extension if your estimate of taxes was not reasonable.
Tax refunds
The IRS encourages taxpayers seeking tax refunds to file their tax returns as soon as possible. The IRS anticipates most tax refunds being issued within 21 days of the IRS receiving a tax return if the return is filed electronically, the tax refund is delivered through direct deposit, and there are no issues with the tax return. To avoid delays in processing, the IRS encourages people to avoid paper tax returns whenever possible.
IRA contributions
Contributions to an individual retirement account (IRA) for 2021 can be made up to the April due date (without regard to extensions) for filing the 2021 federal income tax return.
What Do Rising Interest Rates Mean for You?
On March 16, 2022, the Federal Open Market Committee (FOMC) of the Federal Reserve raised the benchmark federal funds rate by 0.25% to a target range of 0.25% to 0.50%. This is the beginning of a series of increases that the FOMC expects to conduct over the next two years to combat high inflation.1
The FOMC released economic projections that suggest the equivalent of six additional 0.25% increases in 2022, followed by three or four more increases in 2023 when it announced the current increase, 2 These are only projections, based on current conditions, and may not happen. However, they provide a helpful picture of the potential direction of U.S. interest rates.
What is the federal funds rate?
The federal funds rate is the interest rate at which banks lend funds to each other overnight to maintain legally required reserves within the Federal Reserve System. The FOMC sets a target range, usually a 0.25% spread, and then sets two specific rates that function as a floor and a ceiling to push the funds rate into that target range. The rate may vary slightly from day to day, but it generally stays within the target range.
Although the federal funds rate is an internal rate within the Federal Reserve System, it serves as a benchmark for many short-term rates set by banks and can influence longer-term rates as well.
Why does the Fed adjust the federal funds rate?
The Federal Reserve and the FOMC operate under a dual mandate to conduct monetary policies that foster maximum employment and price stability. Adjusting the federal funds rate is the Fed’s primary tool to influence economic growth and inflation.
The FOMC lowers the federal funds rate to stimulate the economy by making it easier for businesses and consumers to borrow, and raises the rate to combat inflation by making borrowing more expensive. In March 2020, when the U.S. economy was devastated by the pandemic, the Committee quickly dropped the rate to its rock-bottom level of 0.00%–0.25% and has kept it there for two years as the economy recovered.
The FOMC has set a 2% annual inflation goal as consistent with healthy economic growth. The Committee considered it appropriate for inflation to run above 2% for some time to balance the extended period when it ran below 2% and give the economy more time to grow in a low-rate environment. However, the steadily increasing inflation levels over the last year — with no sign of easing — have forced the Fed to change course and tighten monetary policy.
How will consumer interest rates be affected?
The prime rate, which commercial banks charge their best customers, is tied directly to the federal funds rate, and generally runs about 3% above it. Though actual rates can vary widely, small-business loans, adjustable-rate mortgages, home-equity lines of credit, auto loans, credit cards, and other forms of consumer credit are often linked to the prime rate, so the rates on these types of loans typically increase with the federal funds rate. Fixed-rate home mortgages are not tied directly to the federal funds rate or the prime rate. Although Fed rate hikes may put upward pressure on new mortgage rates.
Rising interest rates make it more expensive for consumers and businesses to borrow. Although, retirees and others who seek income could eventually benefit from higher yields on savings accounts and certificates of deposit (CDs). Banks typically raise rates charged on loans more quickly than they raise rates paid on deposits, but an extended series of rate increases should filter down to savers over time.
What about bond investments?
Interest-rate changes can have a broad effect on investments, but the impact tends to be more pronounced in the short term as markets adjust to the new level.
When interest rates rise, the value of existing bonds typically falls. Put simply, investors would prefer a newer bond paying a higher interest rate than an existing bond paying a lower rate. Longer-term bonds tend to fluctuate more than those with shorter maturities because investors may be reluctant to tie up their money for an extended period if they anticipate higher yields in the future.
Bonds redeemed prior to maturity may be worth more or less than their original value, but when a bond is held to maturity, the bond owner would receive the face value and interest, unless the issuer defaults. Thus, rising interest rates should not affect the return on a bond you hold to maturity, but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.
Although the rising-rate environment may have a negative impact on bonds you currently hold and want to sell, it might also offer more appealing rates for future bond purchases.
Bond funds are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond values due to rising rates can adversely affect a bond fund’s performance. However, as underlying bonds mature and are replaced by higher-yielding bonds within a rising interest-rate environment, the fund’s yield and/or share value could potentially increase over the long term.
How will the stock market react?
Equities may also be affected by rising rates, though not as directly as bonds. Stock prices are closely tied to earnings growth, so many corporations stand to benefit from a more robust economy, even with higher interest rates. On the other hand, companies that rely on heavy borrowing will likely face higher costs going forward, which could affect their bottom lines.
The stock market reacted positively to the initial rate hike and the projected path forward, but investors will be watching closely to see how the economy performs as interest rates adjust — and whether the increases are working to tame inflation.3
The market may continue to react, positively or negatively, to the government’s inflation reports or the Fed’s interest-rate decisions, but any reaction is typically temporary. As always, it’s important to maintain a long-term perspective and make sound investment decisions based on your own financial goals, time horizon, and risk tolerance.
The FDIC insures CDs and bank savings accounts, which generally provide a fixed rate of return, up to $250,000 per depositor, per insured institution. The return and principal value of stocks and investment funds fluctuate with market conditions. Shares, when sold, may be worth more or less than their original cost. Investments offering the potential for higher rates of return also involve higher risk.
Investment funds are sold by prospectus. Please consider the fund’s objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1–2) Federal Reserve, March 16, 2022
3) The Wall Street Journal, March 17, 2022
