What Happens When the Fed Raises Interest Rates

On December 13, 2017, the Federal Reserve raised the federal funds rate target for the third time in 2017. It lifted this short-term rate to a still-low range of 1.25%-1.50%. (The move was widely expected; the pace of economic growth has picked up to 3% in the past few quarters.) Since the Fed raised its benchmark interest rate again – and is expected to continue doing so at some junctures in 2018 – how might it affect your financial plan and investments?

Here are five things to keep in mind:

1. Short-term fixed income investments are strongly influenced by the federal funds rate. The federal funds rate is an overnight bank-to-bank lending rate that the Fed can use to implement monetary policy. Put simply, when the Fed wants to tap the brakes on economic growth, it can raise the fed funds rate, making it more expensive for banks to borrow money from each other. Conversely, the Fed can lower the rate when it wants to boost growth, allowing more money to circulate in the economy.

Because it’s a short-term rate, any changes tend to have the strongest impact on short-term instruments, such as deposit accounts, money market funds, Treasury bills, short-term bonds, and short-term bond funds. When the federal funds rate is rising, it generally means that bank savings accounts, money market funds, Treasury bills, and short-term bonds should pay a higher yield over time.

2. Intermediate- and long-term bonds may be less affected. That’s not to say intermediate-term bonds (generally, those maturing in five to seven years) or long-term bonds (maturing in 15 years or more) won’t feel it. But rates typically don’t rise in lockstep all along the yield curve.

“One thing to keep in mind that when the Fed raises short-term interest rates, it doesn’t mean all interest rates go up,” says Kathy Jones, senior vice president and chief fixed income strategist at the Schwab Center for Financial Research. “Long-term rates tend to be affected by other factors, as well—like the prospects for growth, inflation expectations, and generally the supply and demand for bonds that have attractive yields on a global basis.”

3. The effect on savings accounts, CDs, mortgages, floating-rate notes, and other products will vary. Interest rate changes don’t affect all investment products the same way. For example, rates on short-term certificates of deposit (CDs) probably will rise along with the federal funds rate, but not all CD rates will rise by the same amount. Longer-maturity CD rates may behave like intermediate- or long-term bond yields.

Adjustable-rate mortgages are usually tied to short-term rates, and if so they can be expected to rise. However, fixed-rate mortgages generally track 10-year Treasury bond yields, and won’t necessarily move higher just because short-term rates do¬. Meanwhile, although income from floating-rate notes should rise over time, it doesn’t always happen right away and might be limited by “caps” or “floors” on how much their coupon payments can change.

4. Stock markets may still rise when rates are rising. The S&P 500® index historically has risen during a rate-tightening cycle. Sure, higher rates make it more expensive for companies and consumers to borrow, which should slow growth down—and over time, it generally does. However, rates tend to rise when the economy is improving, and a strong economy is also good for stocks. It’s typically only after monetary policy has become overly restrictive do stocks suffer, but we are likely far from that stage.

“The conditions for additional rate hikes in 2018—wage growth and inflation trending higher, and job growth still robust—are favorable for stocks,” says Liz Ann Sonders, senior vice president and chief investment strategist at Charles Schwab & Co. “Although inflation is often seen as a bogeyman for stocks, it’s not typically until inflation overheats that trouble ensues.”

5. Rising rates underscore the importance of diversification and rebalancing. Rising rates can be a market game-changer, or at least a signal that economic and market conditions are changing. A well-diversified portfolio can help keep you from being overexposed to areas of the market that may not perform as well in the future as they have in the past, and also help ensure that you’re appropriately weighted to investments that may now outperform.

Periodic rebalancing can help, too. Over time, “winning” investments will gain in value and take up a larger portion of your portfolio, while other investments will shrink in comparison. That can leave your portfolio unbalanced, and potentially increase your risk when market conditions change. Rebalancing involves periodically buying and selling assets to bring your portfolio back to your current desired asset allocation.

“Investors can’t control interest rates,” Jones says. “But they can control what they own and how they position their portfolios for a range of potential outcomes.”

We’re here to help. Feel free to reach out to us if you have any questions or if you would like to review your investments as we welcome the New Year.

Adapted from:

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