Higher Interest Rates – a Big Deal?

Economists agree that the Federal Reserve is likely to “raise interest rates” sometime later this year. Rate hikes are neither categorically good nor bad – what they mean can be complicated. Rates were last raised long enough ago (2006) that many of us have forgotten how it looks and what it means. Here is a quick primer on the topic, an outline of how we think about it while managing portfolios, and a few ideas you can consider to prepare your personal finances.

The Fed Funds Rate – the most interesting rate in the world?

The Federal Funds Rate is the interest rate that US banks are expected to pay to borrow funds from each other on required reserves at the Federal Reserve Bank. It is the Fed’s target for the shortest of short-term interest rates in the US financial system. To combat the crisis of 2008, the Fed aggressively dropped the Fed Funds Rate target to 0 to 0.25%, and it hasn’t budged since.

One might assume that by influencing very short rates, and using other available tools, the Fed can masterfully orchestrate every interest rate in the economy. However, longer term interest rates, whether on a 10-year treasury bond or a 30-year mortgage, are considered to be influenced primarily by market expectations for future economic growth and inflation. A rate hike would normally signal that the Fed believes the economy is running at full capacity and possibly its intention to curtail any bubbles or excess inflation. This was certainly the case with respect to the housing market during its last rate raising campaign from 2004 to 2006 when the Fed took the Funds Rate from 1% to 5.25% over the course of seventeen consecutive meetings.

You are not the only one if you are thinking to yourself that the current economy doesn’t feel anywhere near overheating. Why would the Fed act now? Instead of targeting an obviously overextended part of the economy, a rate hike this year could be viewed as a move toward normalization. While the economy is improving and the Fed understandably wants to stay well ahead of any possible inflationary issues, this may be more about signaling to the market that short term rates near zero aren’t the norm and won’t be here forever. Since 2008, the Fed has run a series of monetary experiments that are unprecedented in scale and scope. A rate increase is the next logical step in unwinding these policies.

Current situation

In our view, overall stock and bond prices move more in anticipation of economic events than in response to today’s headlines. This would suggest that Fed action later this year might be met with a yawn. However, given the unique nature of this cycle, we expect periods of increased volatility for asset prices.

Today’s data show a bias toward a strengthening economy. If this momentum builds, we can expect higher rates across all maturities. This isn’t all bad news – mortgages, for example, will get more expensive but yields available on savings products and municipal bonds will go up as well. There is some truth in the argument that lower interest rates favor borrowers while higher interest rates benefit savers – the reality is that most of us do some of both.

We recently noted that equity markets have generally performed well when rates are moving higher from very low initial levels. There are businesses that have traditionally done better during periods of rising rates – banks, for example. Considering the interest rate sensitivity of current and potential investments is part of our investing process.

Of course, bonds have a more predictable relationship with interest rates – rates go up, prices go down. However, the impact is not uniform. We believe the benefits to owning bonds, especially for those spending from their portfolios, outweigh the evident risks. In general, we are focusing on short and intermediate fixed income investments that are less sensitive to interest rates than long-term bonds. We would welcome the opportunity to buy quality bonds at lower prices and better yields.

Concerned about higher rates?

A few steps you may want to consider:
• Acting sooner rather than later if you are considering a home or other major purchase that will be financed
• Refinancing existing floating rate mortgages, HELOCs, or other longer term debt into fixed rate loans
• Reviewing your fixed income funds or related investments

The path to higher interest rates is impossible to predict. The most practical approach is to be aware of a range of possible outcomes and understand how you can best position your portfolio and personal finances.