What Should You Know About Fed and Interest Rates?
Next week’s Fed Open Market Committee (FOMC) meeting is drawing heightened interest, with a strong consensus among economists and others that an interest rate hike is likely. If so, it would be the first rate hike in a year – and that increase was the first in 7 years.
It’s a tense time for many because we’ve been used to exceedingly low rates for nearly a decade. Indeed, not only will markets be focused on the rate, but also on what the Fed says about the economy at the same time. Whether the Fed chooses to increase rates or does nothing, every word accompanying its action will be parsed for signals about what’s to come.
If rates are hiked, will there be more increases to follow? If rates remain the same, will the Fed indicate that an increase might soon be coming? For your portfolio, what the Fed says might be more important than what it does.
Impact on Your Investment Portfolio
It’s important to understand that the Fed controls just 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.
The ultra-low Fed funds rate for the past 8 years is a historical outlier. In the 70s and 80s, the rate was never lower than 5% except for one 4-month period in 1971 when it was 3.5%. In the 1990s, it never got lower than 3%. Until December 2008, when the Fed cut the rate to 0%, it was never below 1%.
Despite all of the attention on the Fed’s interest rate policy, its impact on the economy and the markets is debatable. The movements of longer-term rates – anything beyond a couple of years – effectively are set in the borrowing marketplace. Economists and Wall Street experts who are trained in understanding interest rates have a difficult time projecting where short- and long-term rates are going and their impact on individual investors.
“For long-term investors, it makes sense to have an understanding of interest rates,” said Joe Correnti, vice president of brokerage product at Scottrade. “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 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.
And what if the Fed holds? Then it’s important to read the Fed commentary or explanation to determine what the future might bring. Is there a bias to increase rates in the future?
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 reducing short-term interest rates, bond prices could begin to rise. If the Fed is moving through a period of raising short-term rates, bond prices are more likely to fall. However, if you hold individual bonds to maturity, you typically will get all of your principal back.
It’s also worth noting that the bond prices typically will move up or down in anticipation of an upcoming rate increase.
- 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. But there are no hard-and-fast rules.
When the Fed raised interest rates on Dec. 16, 2015, by .25% a year ago, U.S. stock markets appeared to barely notice. For a couple of weeks, they bumped up and down a bit. But on Dec. 30, the market fell and kept going south for more than 6 weeks. The S&P 500 dropped 12% before finally recovering in mid-February. Was that related to higher rates? It’s hard to know. But the market has fully recovered and then some.
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. The lower the Fed rate, the lower the rates 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 if the Fed raises its short-term rates.
*The Fed controls the Fed funds rate, which is the interest rate that banks or similar institutions charge other banks for unsecured short-term loans (typically overnight) to help meet Federal Reserve requirements.
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