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Fed says no rate hike, but rates may still go higher

COMMENTARY The Federal Reserve announced today that it will leave rates low through late 2014. Don't confuse this announcement as meaning most interest rates will stay low.

The Federal Reserve asserted it will keep the Fed Funds rate at the near-zero level it is today. That's the overnight rate a bank can borrow funds. The length of the loan is only one day. I have every reason to believe the Federal Reserve will keep rates low through 2014, but don't believe this means that bond rates and mortgage rates will stay low.

The Federal Reserve only controls short-term rates through the announcement made today. Financial markets control intermediate and long-term rates. To see this, one need only to look back a few years when the Federal reserve pushed up short-term rates. Investors didn't buy that inflation was going up and we experienced what is called a negative, or inverted, yield curve, where short-term rates were higher than long-term rates.

What does this mean for your portfolio? It means that you shouldn't get overconfident about the prospects for long-term or even intermediate-term bond funds. If markets view future inflation, the Federal Reserve will be virtually powerless to stop longer term rates from rising. A mere one percent increase in intermediate-term rates could cause a bond or bond fund like the Vanguard Total Bond Fund ETF (BND) to decline about 5 percent. The same 1 percent increase in long-term rates could cause a long-term bond or bond fund to decline 10 percent or more. That could come as a shock for investments that most people think of as "safe," especially because such funds have had great track records recently.

Don't read this as a prediction of rising longer-term rates. Economists have an awful track record of predicting inflation and longer-term rates and I'm not going to join their ranks. Just understand that there is clearly more downside than upside when it comes to bond returns.