Anyone who has paid attention to the financial news over the last few weeks has probably noticed that the talking heads have been spending lots of time pontificating on when the Federal Reserve will begin raising interest rates. One of the biggest pieces of financial news over the last week was that a single word, patiently, was removed from the Fed’s forward guidance. I’m sure it’s caused many of you to wonder about the importance of the interest rate set by the Fed and how it will affect you in the future. The reality is that it will affect few people directly.
The Fed controls what is known as the Fed Funds Rate, which is the short term interest rate the Fed pays to banks on bank reserves. If the Fed raises the interest rate they pay on bank funds held with the Fed, they’re providing an incentive for banks to hold their funds rather than loaning out money. This change in interest rates will not be noticed immediately by individuals; the biggest group affected by this change will be corporations who fund their operations through short term financing from banks. The Post-2008 recovery has been fueled by cheap funds, spurred by the fact that the Fed Funds Rate has been near or at zero since the financial crash. The glut of cheap financing for corporations has led to all time highs in the stock market.
The next thing that will be affected is bond yield. Bond yields will feel upward pressure due to the higher interest rates decided on by the Fed. Higher bond yields are both good and bad for investors. Many investors use a mix of corporate and government bonds as the backbone of their investment portfolios; as we know, when bond yield goes up, the price of the bond goes down. So rising interest rates will lower the value of bonds currently held, which is bad for investors who don’t plan on holding their bonds to maturation. For investors who use bonds for income and plan on holding their bonds till maturation, this will be good. Particularly for investors who own intermediate term bonds with durations between five and ten years, investors will have the ability to hold their bonds till maturation and then reinvest their principal into bonds with higher yields. The ability to reinvest in bonds with higher yields will allow investors to gain greater income from their investments. This will be helpful for many seniors who are struggling to survive on the low yields provided by bonds in the current yield environment but like the safety provided by bonds.
Speaking of investors, this brings me to my next point: equities. To be completely honest, I don’t know how equities will react in a rising interest rate environment and neither does anyone else. All we can do is make educated guesses based on past performance. There have been several instances of rising interest rates in the last thirty years and rising interest rates are generally seen as a byproduct of a healthy economy, however the economy and the stock market aren't the same thing. At times the stock market moves opposite direction overall economy, the stock market going down while the economy grows. We’re currently one quarter into the 7th year of the current Bull market; a bull market of this length has only occurred four times since the end of World War Two. It’s prudent to expect volatility ahead in the stock market, even a market correction downward of 10% or more fueled by a change in interest rates, economic weakness in Europe, global instability, and the eventual rise in oil prices. The important thing is having a portfolio which has a suitable allocation to different asset classes. By holding a portfolio diversified between stocks, bonds, and real estate, it is possible to mitigate the risk of rising interest rates.
Oh, and this might not be a bad time to lock in a home loan or refinance. Mortgage rates are near their all-time lows and a raise in the Fed Funds Rate will eventually trickle down and raise mortgage rates.
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