How Higher Interest Rates Can Impact Your Portfolio
With the Fed raising its key Fed funds rate to .5% from .25%, you might be wondering what it means for you.
For starters, the market was anticipating such a rate hike. So the fact that the increase was in line with expectations, could mean a relatively muted impact on stocks, according to Joe Correnti, senior vice president of brokerage product at Scottrade.
“The market tends to make significant short-term moves when there are surprises,” Correnti said. “And this wasn’t a surprise. But the longer-term impacts remain unknown. So there could be volatility tied to that.”
Let’s review first, what the Fed did.
Fed Funds Rate
The Fed actually controls only one set of short-term interest rates, called the Fed funds rate. That’s the interest rate that banks or similar institutions charge other banks for unsecured short-term loans (typically overnight) to help meet Federal Reserve requirements.
This increase was only the second in 8 years; the last was a year ago when the Fed hiked it from 0 to .25%. While the market has been used to a near-zero Fed funds rate, the last 8 years have been an outlier. Until 2008, rates had never been below 1%.
Generally, longer-term rates – anything beyond a couple of years – effectively are set in the borrowing marketplace. Everything from the rate that companies pay to fund long-term capital expenditures to short-term payday loans are set by competitors. An increase in the Fed funds rate could have little to no impact on those rates.
For example, following the December 2015 Fed funds increase, 30-year mortgage rates actually fell throughout most of the year.
In the meantime, you should also pay attention to what the Fed said as it increased the rate. Given that the stock and bond markets were expecting it, they will also try to anticipate what the Fed will do in 2017.
Impact on Your Investment Portfolio
Of course, there could be differences this time around. If the Fed continues raising interest rates, then perhaps there could be a more significant impact on longer-term rates. The bottom line is that economists and Wall Street experts who are trained in understanding the movement of interest rates have a difficult time projecting where rates are going.
This level of uncertainty illustrates the importance of developing and sticking to a diversified investment plan.
“Trying to predict what the Fed might do, and how the markets will react, can be challenging,” Correnti said. “For long-term investors, it makes sense to have an understanding of interest rates, but it might not make sense to make a lot of changes to a well-diversified portfolio based on where you think rates are headed.”
Impact on the Economy
When the Fed lowers interest rates, the primary objective is to stimulate the economy, in part by making it easier and less expensive to borrow. For example, home buying tends to increase as interest rates move lower. Conversely, the Fed will raise interest rates – as it has in this case – in the hopes of heading off inflation, which can result from an overstimulated economy.
But, as noted above, longer-term interest rates might not move much based on the Fed funds rate.
Impact on Securities
- Fixed-income. The price of a bond typically rises when interest rates fall. When interest rates rise, bond prices usually fall. So if the Fed is moving through a period of raising short-term rates, bond prices could fall. However, if you hold individual bonds to maturity, you typically will get all of your principal back.
- Equities. The impact of interest rate movements are less obvious or consistent when it comes to stocks. For example, although the stock markets – at least initially – tend to react negatively to rising interest rates, some sectors actually perform better with rising interest rates.
Impact on Savings and Borrowing
- At the most basic level, the Fed’s short-term interest rates serve as a barometer for rates that you might get through a bank checking or savings account or a money market account. A higher Fed funds rate, the higher the rate you’re likely to receive.
- For borrowers, higher rates can lead to higher borrowing costs. For example, if you have an adjustable rate for a credit card or mortgage tied to the prime rate, your rate could increase with the increase in Fed rates.
Diversification may help spread risk, but it does not assure a profit, or protect against loss, in a down market.
Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk, credit risk, market risk, default risk, event risk, and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available by contacting Scottrade. Investors should read these carefully.
The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.