Higher interest rates are coming. Take a deep breath. It seems like higher interests are something to worry about, but they aren’t. Something to prepare for? Yes. But worry? No.
Whenever the financial or popular press mentions that the Federal Reserve may raise interest rates, people work themselves into a tizzy fed by worry and speculation. It has been a long time since we experienced a hike in interest rates, so it is only natural that even the possibility of such a move makes us nervous.
However, when the Fed raises rates – probably between an eighth of a percent and a half of a percent in the next nine months – the immediate impact will be negligible. Why negligible? If you look at future interest rates, you’ll see the markets are already assuming a rate hike, so there’s no impact in the immediate future.
But what about later? That more-distant-but-not-so-far-away future depends on what the Fed does after that first rate hike. Will the Fed go into a tightening cycle, and if so, what impact will that have on stocks, bonds and other types of assets? Let’s explore that scenario.
The possibility of a tightening policy may give the stock market jitters, given that when the Fed tightened policy in 1937 it sent the country back into depression, but, the Fed learned from this mistake and is unlikely to make a move that risks disrupting continued growth. Looking at the S&P 500, we see that as the Fed applies a tightening policy – incrementally increasing rates in small steps – the stock market does well, or at least it did during the last 3 tightening cycles. It goes up because generally, if the Fed is raising rates, the economy is doing better, which is good for stocks. So investors can take a deep breath.
On the bond side of things, a tightening cycle will not lead to – as some believe – bond-mageddon. Yes, bond prices are likely to fall, but past tightening cycles show that bond price declines never reached drastic levels. So resist the impulse to sell off your bonds. These are useful in your portfolio as a hedge against any unexpected events that may impact the economy. Besides, any decreases in your bond portfolio may be offset by increases in your equity portfolio as the market goes up.
From the perspective of savers, a tightening cycle with increasing interest rates is a good thing. The low interest rates world we have been experiencing has been rough on savers. Back in 2006 when rates were higher, for example, if you put $100,000 into six-month CD, you earned $5,240 a year but at the end of 2014, the same investment only generated $130 for the year. The lower interest rates have forced many conservative investors to put their money in riskier investments, so increased rates would allow them to move back into their investment comfort zones.
When the Federal Reserve raises interest rates, there is no doubt that mortgage interest rates will follow suit. So if you’re in the market now to buy a house or refinance, it’s probably a pretty good time. That said, given that inflationary pressure looks limited by excess capacity, especially internationally, and relatively low commodity prices, we don’t expect long rates, which drive mortgage rates, to make a dramatic move up. Substantially higher rates could happen, but that’s highly unlikely unless we get real inflationary pressure.
As you can see, rate increases by the Fed are nothing to fear, but they will bring changes. Having a well-diversified portfolio may help put you in the best position as those changes roll out.
Just keep in mind that the Federal Reserve only increases interest rates when the economy is doing well.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
The Standard & Poor’s 500 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.
