In July, the St. Louis Fed reported that the effective federal funds interest rate was 0.18%. The federal funds rate is considered one of the most important interest rates in the U.S. markets. In fact, the federal funds rate has been near zero since late 2008. In this incredibly low interest rate environment, there are some investments you'll probably want to avoid, as well as some better choices for where to invest.
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What to Avoid
When the average one-year CD is yielding a paltry 1.3% you may be tempted to buy a longer-term CD in order to get a better yield. Currently the average rate on a five-year CD is about 2.6%. It is probably a bad idea to lock in for the long term at such low rates. If inflation returns, these low interest rates might turn out to yield little to no real return.
There is no way to tell exactly when rates will rise again, but with the federal funds rate so close to zero, we do know that buying a long-term CD would be locking in some of the lowest rates we're likely to see. If you do choose to go with a long-term CD, try to choose one with a low early withdrawal penalty, so that if rates do rise sharply you will be able to move your funds.
Bonds have a strong inverse link to interest rates. That is, when market interest rates increase, the prices of existing bond issues decrease. In addition, the longer it is to the bond's maturity, the more sensitive its price is to changes in the market interest rate.
Due to these facts, long-term bonds are usually a bad choice in a low interest rate environment. This is particularly true since the federal funds rate is so close to zero. There is nowhere for interest rates to go but up. As interest rates climb, long-term bond prices will fall significantly, resulting in losses on long-term bond portfolios. (To learn more about bonds, take a look at our Bond Basics Tutorial.)
Where to Invest
Unlike many other investments, low interest rates are good for stocks, at least in theory. Since companies are able to borrow money at lower rates in the market, they are able to fund more growth initiatives. If these investment programs are successful, then you would generally expect stock prices to rise due to increased earnings.
In reality, it is much more difficult to say how stocks will behave in a low rate environment because there are so many confounding factors. One of the major confounding factors is that low interest rates often coincide with poor economic conditions. So, as we have seen over the past couple of years, it could be that the Fed will lower interest rates dramatically, but stocks will still fall in anticipation of a recession.
Despite the uncertainties involved, stocks remain one of the better choices if you like other fundamental indicators in the economy. They give a chance to benefit from low interest rates, and are generally not expected to decline sharply when interest rates rise.
Short-term bonds can be a good choice because they are much less sensitive to changes in the market interest rate. In fact, if you are able to hold a short-term bond to maturity, you don't even have to worry about changes in a bond's price. This is because bond investors have an option that stock investors do not -- rather than selling the bond, they can simply wait to get the principal amount back at maturity.
Short-term bonds usually don't pay as high of an interest rate to investors, but a modest return is still a good result as you wait for more promising investment opportunities.
The Bottom Line
Picking the right investments in any environment involves a certain amount of luck, but by understanding how interest rates are linked with certain types of investments, you can put the odds in your favor. (For related reading, take a look at Save Smart With A CD Ladder)