At the end of March, the Federal Open Market Committee (FOMC) announced that it was increasing the fed funds rate by 0.25%. This rate, which is also known as the “overnight rate,” is the rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis so that those institutions can meet their reserve balance requirements. The general consensus is that this increase is the first of three this year although some analysts think there could be as many as four rate hikes in 2018. As these rate hikes occur, it is important to know that upticks in interest rates can create investment opportunities – if you know where to look.
The underlying reason why interest rates go up is good news – it is a signal that the economy is improving. Recent market and industry reports on the performance of the financial and labor market, as well as household and business spending, have shown moderate increases. Market watchers expect this pattern to continue in the coming quarters, which supports the expectations of additional interest rate increases this year.
Why interest rates rise
To better understand why interest rates tick up, let’s look at the causes of that change. The FOMC increases the interest rate to control inflation by making money more expensive to borrow. When banks must pay more to secure the funds they loan, they pass this higher cost on to their customers by raising their lending rate. Banks’ increased rates mean consumers pay higher mortgage, credit card and loan payments. These higher payments kick in quickly, especially for those with variable interest rate loans. When consumers have less money left at the end of the month, discretionary spending slows which tends to dampen inflationary pressures.
Even though it routinely takes up to 12 months for a rate increase’s effect to permeate the economy broadly, market response is often immediate. For businesses with outstanding loans, an interest rate hike can constrict the flow of cash, potentially stalling expansions, acquisitions and investments in facilities or equipment. For public companies, constrained cash flow can lead to a decline in stock prices. As more companies are affected by this restraint of cash flow, the broader market can be affected, making stock positions less attractive.
However, there is a positive side to this for equities as well. Rising interest rates indicate that the economy is improving. An improving economy generally results in a positive job market and increased wages. Higher wages put more money in people’s pockets leading to increased consumption. Since consumption is 70% of our GDP, this drives economic growth higher.
Initial drop in bond values doesn’t last
An uptick in interest rates generally depresses bond prices initially. Consider that if an investor originally purchased a 3% bond and rates go up 0.25%, that 3% bond will no longer be as attractive, depressing the underlying value of the bond. Bonds with longer maturities will see more fluctuation than those with shorter maturities. Going back to the 3% bond example, it is one thing to have a bond with a 5-year maturity that has a below market interest rate. A 10-year bond would be even less attractive. However, despite the expected fall in bond prices, bonds continue to appeal to investors that need income or are more conservative. Historically, high quality bonds have conserved capital over the long run, provided income, and offered a low-to-negative correlation to equities. If you want to invest in a down bond market, look for newly offered government securities. Because they are newly issued, these bonds will reflect prevailing interest rates and, because they are backed by the U.S. government, have a high degree of security of principal.
Remember that investor psychology also comes into play when interest rates go up. For example, if the word on the street is that a coming increase will be 50 basis points but the actual bump is 25 points, this news, which on its face seems encouraging, can still trigger a market decline. In general, financial markets do not like uncertainty. When the unexpected happens, be it a smaller or larger increase than anticipated to interest rates, volatility can occur. Also, although the general consensus is that rates will rise this year, the impact on the financial markets is never a certainty. While it is true that the stock market usually goes down initially with an interest rate hike, the opposite happened in 2013. In that year, interest rates went up and the market followed in a positive fashion proving that even the most widely held investing tenets don’t apply 100% of the time.
So, in the face of the high likelihood of increasing interest rates this year, what should a prudent investor do? At AFA, we continue to believe that maintaining a diversified investment portfolio across asset classes provides investors with more predictable returns over the long run while mitigating volatility as much as possible. If you have questions, please call our office for a consultation. We are always happy to discuss prevailing market conditions and how that might impact your own personal 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. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results.