No matter where you turn these days, news broadcasters, financial pundits and market watchers are talking about the Federal Reserve and what they will do with interest rates. Will they continue to increase rates or become more accommodative and slow down their increases? Since the 2008 financial crisis, the Fed has raised rates eight times (once in 2015, once in 2016, three times in 2017 and, so far, three times in 2018). What will happen next?
Conventional wisdom is that the Fed will raise rates once again this year at their December meeting (to 2.5%) and likely three more times in 2019. However, recent market volatility and some mixed economic signals have brought this thinking into question. The U.S. continues to have strong GDP growth and low unemployment but there are signs of weakening consumer confidence and inflation on the horizon. Given this backdrop, there are now some questions about how far the Fed is willing to push interest rates. On Wednesday, November 28, Fed Chairman Jay Powell said he felt rates were “close to neutral,” meaning that additional rate hikes could be less than expected. And, on that news, the financial markets soared with the Dow Jones up more than 600 points that same day. It is clear that the Fed has a very difficult balancing act – keeping the economy from over-heating and avoiding financial bubbles that can occur when rates are too low for too long, while, at the same time, avoiding raising rates too fast and choking off still positive economic growth.
The higher the Fed pushes interest rates, the more consumers and businesses pay for the money they borrow. Mortgage and loan rates, as well as credit card interest charges, respond to the Fed’s action quickly – sometimes the same day. That’s because as the Fed increases its interest rate, the prime rate – the amount offered banks’ most credit-worthy customers – mimics the Fed’s action. A higher prime rate pushes up the fixed and variable rates the banks charge their customers. Often, the financial markets take a downturn on just the inference that a rate hike could be coming.
In September, the Fed raised the rate for the third time this year, putting the Fed funds rate at the highest level since April 2008. However, the Fed surprised most of us last month when it opted to not raise rates at that juncture. Because the Fed chose not to hike rates in November, financial pundits are looking at the Fed’s December meeting as another likely opportunity for a rate increase. These same market watchers are predicting the Fed will raise rates at least twice in 2019 and more likely three times.
Hot Economy Usually Triggers Rate Increase
What many investors fail to recognize in the current financial environment is the silver lining that comes with rate hikes. The Fed ups the interest rates to avoid an over-heated economy. The objective is an economy where financial and labor markets are performing well, and there is robust spending on the part of businesses and consumers. When the pundits expect these positive trends to continue and start to worry about inflation, look for the conversation predicting a Fed rate hike to pick up.
Often, a drop-in bond values follows a rate hike, but the initial downturn usually doesn’t last. Besides, the type of investor drawn to bonds, either as a way to generate income or conserve capital over the long term, should not be repelled by a short-term dip.
Moreover, the real reasons why rate hikes generate so much attention is not the rate increase itself but the market’s and investors’ reaction to it. Financial markets do not respond well to change of any kind, which makes a rate increase unattractive not on its own merit but because of the uncertainty surrounding it. And remember, a rate hike doesn’t always mean stocks will be depressed. In 2013, interest rates went up and the financial markets grew as well.
A diversified portfolio can navigate through just about any financial uncertainty, including potential rate hikes. In the majority of cases, diversification offers an opportunity for long term growth across a wide variety of economic cycles. If you would like to know more about how the Fed’s rate increases and its recent actions could be influencing your portfolio, contact your wealth manager today.
The opinions voiced in this article 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.