What Do Rising Federal Interest Rates Mean for You?

in Financial Planning by

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.

[Track the impact of debt on your net worth with Personal Capital’s free tools]

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.

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk is a member of the Personal Capital Advisors Investment Committee. He also serves as Vice President of Portfolio Management. Prior to Personal Capital Advisors, he was an integral leader within the portfolio management team at Fisher Investments. During Craig’s time there, the company increased assets under management from $1.5 billion under management to over $40 billion. His responsibilities included risk management, portfolio implementation oversight, and management of all securities and capital markets research analysts. Mr. Birk graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.

One Response

  1. Tim

    As you explain “duration” is a one year metric. Duration is not as close to “average maturity” as some fixed income investors are understanding of or led to believe. Using the term Duration “probably” does not reflect the risk in owning Aggregate Bond funds over a period of consecutive yearS. The FED coined the Word “Gradual” in their creation of the 2013 September SURPRISE. Bill Gross is calling 2.6% for the .TNX as the signal that the +30 year bond rally has ended. Gundlach is more sanguine with his call for a 3.0% .TNX as signaling the end. What if the US bond market does a redux of the last 8 years of the US stock market and buying the dips pays off over a period of years. Buying the dips with cash raised selling the rallies. Bonds continue to represent financial repression and provide punitive yields in maturities that could be considered “safe”. Bonds and not especially bond FUNDs can be expected to provide some stability to portfolios but can they provide adequate returns for retirees? So the classic advice that the retired NEeD to have a substantial position in bonds of more than 60% may not be as valid as holding a first bucket in cash. Bonds will not provide enough income to contribute to retiree SWRs of 3% to 4%. IG 3.5 to 5 year commercial bonds as 8% to 15% of a portfolio may be valid in a laddering strategy to create a bar bell against the dips in Bonds and peaks in rates knocking back Utes,Telecoms, and US TBTF bank preferreds. Most preferreds are perpetual or have the potential of becoming perpetual. But their margin in Yield ~ 5.8% has significant advantages. Against a near metric the .TYX now dipping below 3.15%. An investor can get nearly an extra percentage more in yield by taking a 3% – 3.5% distribution on preferreds’ distributions and reserve the rest for re-investment. As rates rise GRADUALLY the value of the original preferreds cost basis’ could SLOWLY be eroded. But that is way over compensated for by the margins in yield of ~5.8%. In a cash/margin acct the dividends of preferreds of TBTF US Banks get the tax advantaged treatment. In IRAs under accumulation or under SWR distribution these shares can eventually be transferred in kind to a taxable account to meet MRDs past 70 1/2. As long as the tax laws remain the same. There really is no rhyme nor reason why and when preferreds get called. But enough of them in a diversified portfolio of them will be called to provide cash to attach your excess distributions to for re-investment on a regular basis, at higher rates and lower prices as rates GRADUALLY climb. The heresy is that the investor is concentrating on creating an increasing income and not so concerned about an eventual small loss of principle. That loss will be way offset by the margin in yield and the tax advantages in a GRADUALLY rising interest rate scenario. Given what has occurred since the .TNX hit 2.65%, and the uncertainty about economic policy why could the .TNX not average 2.15% in 2017 ? Financial repression has not been repealed just because rates have risen from almost Zero to a little more than Zero. Of the $4.2 trillion the Fed is holding $3.1 Trill is Q/E generated out of printed money. The FED can hold down rates just by how they do their re-fundings. If they abandon buying any <5 yr bonds the supply will rise causing ST rates to rise from .5% rates but by instead buying 8 to 12 year maturities longer term rates can be made to continue on being manipulated to hold to the low rates or even decline in yield as they pressure the supply with their purchases. The 1 yr US treasury could move to a .975% mark. But the .TNX and .TYX just say stalled below the Gross and Gundlach harbingers. If you are a bond analyst you have to believe in Bonds and maybe more so in bond FUNDs owned by itchy trigger finger retail investors. But there might be other safer and more effective yield investments against inflation asserting and in their margins in yield vs their relative safety. So bar belling them might be a better strategy than trying to do a long barbell end in bonds vs safer Shorter term maturity IG bonds. When the Gov't stops stress testing TBTF banks and they can increase dividends on common without permission maybe 5.5% to 6.5% perpetual subordinated debt distributions will no longer be safe? When the TBTF banks no longer face public and Gov't censure for obscene incentivizations and compensations. When rates rise rapidly. Whenever all that happens…maybe in the next decade AFTER Tokyo 2020?

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