The goal of the Federal Reserve is to keep the economy growing at a steady pace, not too hot, not too cold. They want to keep prices stable and unemployment low. When the economy gets “too hot” the Fed will step in and raise interest rates.
Why Raise Rates?
Consumer prices were up 8.6% from a year ago, a 40-year high. In an attempt to regain control over soaring prices, the Fed announced the largest rate hike in 28 years.
By increasing interest rates, borrowing becomes more expensive. In theory, this slows demand for goods and taps the brakes on inflation. Higher interest rates make loans more expensive for both businesses and consumers.
The ultimate question is how high will interest rates continue to climb. If Wall Street’s estimates come to fruition, rates could rise to 3.5% – 3.75%, the highest level since 2008. How could this increase impact your finances?
Impact on Stocks
When the Fed increases rates, lenders raise borrowing costs. Mortgages, credit cards, and other loans become pricier, reducing consumer’s spending power and thus decreasing demand. Companies also pay more to finance their operations. Over time, higher costs and less business could lead to lower revenue for companies.
Still, there’s no guarantee that rate hikes will negatively impact stocks long term. Typically, rising interest rates occur during periods of economic strength. Surprisingly, stocks have held up relatively well during past rate hiking cycles. The average annual return was 9.4% during these periods.
Impact on Bonds
Bonds are particularly sensitive to interest rate changes. The U.S. bond market is on pace for its worst year in history (down -11.5% YTD). This is a direct result of the sharp increase in rates.
When interest rates increase the price of existing bonds usually fall. That’s because new bonds will soon be coming off the market offering investors higher interest rate payments. Existing bonds will come down in price to make their comparatively lower interest rate more attractive.
Bonds could continue to decline if interest rates continue higher. But predicting the movement of interest rates is one of the more difficult things to do in financial markets. Even professional forecasters struggle to forecast future interest rates (see below).
Impact on Mortgages
The Federal Reserve doesn’t set mortgage rates, but it does affect mortgage rates indirectly. So far this year, mortgage rates have consistently risen ahead of the Federal Reserve meeting. Recently, the rate for a 30-year fixed mortgage hit a high of 6.28%.
A sharp rise in interest rates has made owning a home even more expensive. For example, if you took out a mortgage on a $500,000 house with 20% down these would be your payments:
$1,611/month at 2.65% interest
$2,470/month at 6.28% interest
That’s an increase of ~$850 per month! If interest rates continue to rise, the cost of borrowing will increase. One positive is we could start to see housing prices decline to adjust for the higher costs.
Impact on Consumer Credit
Consumers should expect to pay more for new car loans, student loans, and credit card debt. During a rising rate environment, consumers should consider the impact that higher rates will have on their loans. If you have any variable rate loans, they will likely increase if they haven’t already.
Impact on Savings Accounts and CDs
While higher interest rates might be bad for borrowers, they’re great for anyone with a savings account. An increase in the Fed benchmark often means banks will pay more interest on deposits.
The interest rate on high yield savings accounts are around 1.00% and could climb higher. Certificates of deposits (CDs) have begun to move higher as well. According to Bankrate.com, 1-year CDs are as high as 2.0%.
Bottom Line
As in any market condition, striking the right asset allocation among stocks, bonds and cash is the best way to mitigate the impact of rising rates. Depending on your time horizon, the current market decline could serve as an opportunity to buy stocks at lower prices.
George Maroudas
847-550-6100
george@pmgwealth.com
Twitter @ChicagoAdvisor
Sources and Disclaimers
Federal Funds Rate is the target interest rate set by the Fed at which commercial banks borrow and lend their extra reserves to one other overnight. Source Investopedia
Target Rate Probabilities for July 27th Meeting from CME Group
US Inflation Quickens to a 40-Year High from Bloomberg
U.S. stock market returns during rate hike cycles from Reuters
Mortgage rate at 6.28% from Mortgage News Daily
U.S. Bond market on pace for its worst year in history from @Charliebilello
1 Year CD rates from Bankrate
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Please consult your financial advisor regarding your specific situation. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy ensures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. The Standard & Poor’s Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
