After raising interest rates for the first time in three years, the Federal Reserve Bank announced in March that it expects a series of additional rate increases that would bring the federal funds rate to approximately 2.75 percent by the end of 2023. The last time rates were that high was in 2008. What does this mean to consumers and businesses and how can they prepare for those implications?
The Federal Reserve, also referred to as “the Fed,” is the central bank of the U.S., responsible for setting the nation’s monetary policy and maintaining the stability of its financial system through the promotion of maximum employment and price stability. One way the Fed can modify economic policy is to raise or reduce the federal funds target rate, which is the overnight rate of interest banks and credit unions charge each other to borrow money. While this interest rate applies over a very short term, it also tends to have an influence other short-term rates and, to a lesser extent, some longer-term rates that often apply to loans and mortgages, lines of credit and treasury yields. Therefore, when the economy slows down, the Fed can cut the federal funds rate, thereby reducing the costs of borrowing and stimulating consumer spending and business investments. By contrast, if the economy is booming and inflation runs too high, the Fed can try to cool it down by raising interest rates. This will have the effect of increasing the costs of debt and lowering the return-on-investment investors can yield from the safety of treasuries they currently they own.
Not only will an actual increase or decrease in the federal funds rate affect interest rates, but a perceived anticipation of rate changes will also influence the movement of market interest rates before the Fed takes any action. Investors and consumers can gauge these expectations by keeping a watchful eye on the news releases and statements issued by the Fed; the minutes from the Federal Open Market Committee’s (FOMC) eight meetings each year; and the Dot Plot, which charts the FOMC members’ future estimates for the federal funds rate.
To better understand how future expectations affect current market rates, consider that the 10-year Treasury increased from 1.09 percent on January 1, 2021, to 1.93 percent at the end of January 2022, despite a lack of Fed action. During the same period, the 2-year Treasury increased from 0.12 percent to 1.17 percent, a nearly 900 percent increase!
Interest rates are critical for all things financial. They can tell you the costs you can expect to pay for borrowing and the amount you may earn as a reward for saving.
For example, higher interest rates require consumers to pay more for a mortgage, which could, in turn, negatively affect the housing market and reduce the number of people refinancing existing mortgages. Similarly, higher rates make it more expensive for consumers to buy or lease a car or business equipment and carry debt on credit cards.
From a savings and investment perspective, rising interest rates means that consumers will earn more on the money they have saved in the bank and the bonds they purchase in the future. However, it is important to note that bonds have an inverse relationship to interest rates, meaning that when interest rates increase, bond prices typically fall along with the value of existing bond portfolios. Therefore, the bonds an investor purchased at a time when rates were low will lose their value in a rising interest rate environment.
Consider that we have had more than 40 years of falling interest rates, during which time investors could earn large income payments due to higher rates at the time of purchase. As rates fell, the price of those bonds went up. Investors, in turn, have been shocked by negative bond returns.
Another area affected by fluctuating interest rates are stock values, which investors can determine by looking at the current cost of a company’s stock compared to the value of that company’s projected future revenue discounted back to today’s present value. The higher the rate used to discount these cash flows back to today’s value, the lower the current value of the company. In other words, as the discount rate goes up, future cash flow is worth less in today’s dollars as is the investment. This is especially true for investments in high-growth companies that may not be turning big profits today. While an investor may buy stock in those companies today based on projected future growth, consideration of the time value of money and the discount rate may demonstrate that the expected future profits are worth less in today’s dollars.
Working with experienced financial advisors can help you gauge the movement of interest rates and how they can affect you and your unique circumstances. Proper planning may help you mitigate risks.
About the Author: Shane Phillips, CFA, CAIA, CFP®, is a portfolio manager with Provenance Wealth Advisors (PWA), an Independent Registered Investment advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with Raymond James Financial Services. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or via email at info@provwealth.com.
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Shane Phillips, CFA, CAIA, CFP®, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC.
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There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk, and you may incur a profit or loss regardless of strategy selected.
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Posted on May 11, 2022