Last week, the Federal Reserve raised interest rates for the first time this year — only the second raise since 2006 — and indicated that more rate hikes could be on the horizon in 2017. So as the year draws to a close, why now? And what impact could this have on you, as an investor and a consumer?
The History of Interest Rates
The Federal Reserve’s responsibility is to provide consumers with a safe, flexible and stable monetary and financial system. The Fed has the domain to raise and lower short-term interest rates by using open market operations. When times are good, the Fed typically keeps rates higher to keep a lid on inflation. When times are tough, the Fed may lower rates to encourage lending and economic activity.
The Fed has done an admirable job, but its crystal ball is no better than the average do-it-yourself stock investor’s. In both the dot-com crash and the subprime crisis, the Fed only cut rates after things got ugly. Last week, when the Fed raised rates for just the second time since 2006, it indicated that three more hikes are likely in 2017. With rates likely to go up, it’s important to have a high-level understanding of what that means for you, your portfolio and your financial priorities.
The Impact on Mortgages and Credit
A combination of Fed statements and expectations around Trump policy has recently driven longer dated interest rates up, bringing mortgage rates with them. A typical 30-year fixed mortgage now carries a 4.5% interest rate, up from about 3.5% this summer. For perspective, that means an approximate $2,000 monthly payment on a $400,000 loan–up around $200 from $1,800. This has undoubtedly made homes less affordable, but it’s too soon to see this reflected in home prices. We expect the change so far will stabilize home prices, but we don’t see any reason for it alone to send prices downward. Long-term mortgages are based in part on expectations about future Fed rate moves in the near term, so even if the Fed does hike three more times next year, it doesn’t mean mortgage rates must go up a full 0.75%, or even much at all. Then again, they could go up more.
If you are carrying revolving credit card debt, higher rates are bad news because your bank is likely to be slow to pass on higher yields on your checking and savings accounts. However, they likely won’t hesitate to charge higher interest rates on debt. Credit card rates were already high, so it may not feel that noticeable, but hopefully the hikes can provide a new incentive to pay down or eliminate credit card debt.
The Impact on Bond Holdings and Stocks
For investors, higher rates immediately translate into losses on bond holdings because existing bonds with lower rates aren’t as attractive. We see a lot of fear around rising rates and bonds, and much of it is overblown.
The U.S. aggregate bond market has an effective duration of a little over 5. That means if (and again, this is a very big if) rates go up 1% next year, the bond market would see a price decline of about 5%. But after interest payments, it would mean a loss of only about 2%. Similarly, rates this year are slightly up and the U.S. aggregate bond market is up about 1%. This isn’t disastrous, but it’s not ideal (note: holding a lot of long maturity bonds can be much more risky). Meanwhile, yields are now higher which provides a larger cushion against future losses.
For stocks, higher rates tend to mean lower prices because safer alternatives become more attractive. This makes sense, and historically stock PE ratios and interest rates have been inversely correlated. But there are long stretches of time when this has not been the case, so we can’t assume just because interest rates go up next year that stocks must go down. There are always many factors at play simultaneously, and interest rates are just one of them. Stock valuations are high by historical measures, and bond yields are still low. This creates an environment where investors should be cautious – not greedy. But a well-constructed diversified portfolio still has a much better expected return than cash, even if that cash may now earn you closer to 1% than 0%.
What Higher Interest Rates Mean for You
Higher rates bring opportunities and risks. We urge our clients to stay focused on long-term goals and stick with strategies that are proven to work over time. It is worth keeping in mind that the Fed’s Open Market Committee has consistently suggested that it would hike rates over the past few years, yet little has changed. We advise against getting too caught up in extrapolating what future rate cuts may occur and what the implications may be, and instead focusing on implementing a holistic financial plan.
For questions about how interest rates will affect your finances, set up a free consultation with a Personal Capital advisor.
Craig Birk, CFP®
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