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Ready for Rising Rates?

INVESTMENT STRATEGY

by Kevin Barry

You are probably aware that the Federal Reserve has started a process of raising interest rates from the extraordinarily low levels in place since 2008. While, typically, higher interest rates could stem from a disturbing increase in inflation, wages growing too fast, or a strategy to defend the dollar’s value, the rate increase that we foresee is merely a reversion to normal levels as the economy finally gains its sea legs.

But what do rising rates mean for you? How will your household finances be affected? What risks should you be on the lookout for?

Households that are predominantly savers will finally benefit from higher interest income, while those who borrow heavily will feel the pain of increased credit card, auto, and other consumer interest charges. Since most households have both debt and savings, the increase in rates will come as a mixed blessing. This article details the reasons for the rate increases, the potential costs and bene can take to mitigate the impact of rising rates on your net worth.

Why are interest rates so low?

In the immediate aftermath of the financial crisis in 2008 and 2009, unemployment skyrocketed to 10 percent and inflation plummeted. The Federal Reserve was so alarmed about the potential dire impacts of the stock market and housing market collapses that they decided to reduce short-term interest rates almost to zero. They felt that these extraordinarily low interest rates would encourage businesses to invest and consumers to borrow and buy.

While the Fed’s actions kept the economy afloat and rekindled economic growth after the crisis, their actions also hurt savers. Savers have suffered extremely low interest rates on their certificates of deposit, money market funds, and other savings vehicles ever since.

Ultimately, the Fed was willing to benefit borrowers at the expense of savers because they felt that borrowers would spend any income resulting from lower mortgage interest costs—a positive for the economy.

Does the Federal Reserve set the level for all interest rates?

No. The Fed controls short-term interest rates and influences but does not control long-term interest rates. It does this by setting the federal (or fed) funds rate—the rate at which banks lend to each other overnight. For example, while the Fed did not reduce mortgage

rates in response to the financial crisis, their strategy of reducing the fed funds rate brought the 30-year mortgage rate down to record- low levels. Figure One above shows the fed funds rate alongside 30-year mortgage rates since 2007.

The monthly savings many households realized by refinancing into lower-rate mortgages stimulated the economy. Lower monthly payments for new home purchases also meant that more people could buy homes. This increased demand further stimulated economic growth by creating jobs and boosting the sale of the many things that go into a finished home, including lumber, concrete, and appliances to name just a few.

Why is the Fed increasing short-term interest rates?

The Fed’s zero interest rate policy was a response to an economic crisis. But the emergency is long past. The stock market has increased severalfold from its March 2009 low; unemployment has declined from its 10 percent peak to 4.5 percent today. More than 13 million jobs have been created since early 2009. Extraordinarily low rates are no longer needed.

Meanwhile, the inflation rate has increased from near zero in 2009 to 1.75 percent today, and the Federal Reserve would like to see it increase to 2 percent. One predictor of future inflation that the Fed monitors is wages. Wages today are up 2.5 percent year over year, up ago. That’s a positive sign and fits with the Fed's gradual approach to interest rate hikes.

How high should I expect rates to climb?

We expect the Fed to raise the fed funds rate from 1.25 percent— where it sits today—to 2.5 percent by the end of 2018. We expect the 30-year fixed-rate mortgage to increase to 4.87 percent.

Rates could increase further if we experience inflation higher than 3 percent. A number of factors, including wage increases and commodity price shocks (like in the oil embargo of the early 1970s), can drive inflation. Interest rates could also increase more than expected if investors overreact or misread the Fed’s policy intentions. But because the Federal Reserve began laying the groundwork for higher rates before they began the process, the market is prepared for the policy change. While there remains a chance that the Fed could hike rates too rapidly or too high, we do not expect that to be a problem.

Should I refinance my adjustable-rate mortgage?

Despite recent increases in short-term rates, 30-year fixed-rate mortgage rates are still very low.

If you have an adjustable-rate mortgage—for example, a 5/1 or 7/1 ARM—and expect to be in your home for the long term, we recommend you consider refinancing into a fixed-rate mortgage. For most ARMs, when they begin to float, the new interest will exceed today’s 30-year fixed-rate mortgage at 3.87 percent.

What are the impacts of higher interest rates on my income and net worth?

Many people react negatively to the thought of rising rates, but they are not entirely a bad thing. True, higher interest rates will increase the cost of mortgages, credit card debt, and student loans and could negatively impact bond portfolio and commercial real estate values. However, yield-starved investors will finally start to see more meaningful yields on their savings and their bond portfolios.

The impact of higher interest rates on your household and investments will vary depending on the type of debt you have—fixed rate versus adjustable rate—as well as the length of the loan. For example, if your debt is solely a 30-year fixed-rate mortgage and your savings is in money market funds or short-term Treasurys, you will be an unabashed beneficiary of higher short-term rates. Conversely, if you have an adjustable-rate mortgage and large amounts of credit card debt, your interest-cost increase may well exceed any wage increase or higher yield on savings vehicles you experience.

What are the potential impacts on the U.S. economy?

As discussed, an increase in short-term rates favors savers and harms borrowers. Higher credit card bills, for example, should dampen consumer spending on items such as dining out and clothing purchases. Given that consumer spending comprises 70 percent of U.S. economic activity, the need to divert income to pay higher interest charges must, therefore, reduce potential consumption.

The good news is that we also predict a 2.5 percent increase in wages. This extra income is more than five times the amount needed to pay the higher interest costs resulting from a 1 percent increase in short-term rates for the nation as a whole. However, some consumers are more burdened with floating-rate debt than others. For them, a 2.5 percent wage increase may not be enough to offset their higher interest costs.

Will higher interest rates derail the stock market?

Interest rates that increase gradually to the levels we expect should not disrupt the stock market. We believe that an increase of 1 to 2 percent is already priced into the stock market.

That said, interest rates could derail stock market prices if:

  • Inflation exceeds the Fed’s 2 percent target;
  • The value of the U.S. dollar declines inordinately; or
  • The cost of margin borrowing rises to a level sufficient to cause selling.

The biggest factor we will be monitoring is wages. Wage inflation has increased over the last five years. If wages begin to rise at an annual rate greater than 4 percent, both short- and long-term rates would increase more than we currently expect as the Fed acts to head off inflation.

As always, the stock market could also be buffeted by other factors, including geopolitical risks in North Korea and else a decline in earnings, or a return to higher levels of volatility.

What sectors of the stock market will do better (or worse) with higher rates?

Corporations, too, can be net borrowers or savers. As a result, rising interest rates affect sectors disparately. A couple of the most interest-rate- sensitive stock market sectors include:

  • Utilities. Their bond-like attributes mean that utility stocks would likely underperform if interest rates increased by 1 percent or more. While utilities’ earnings are steadier and more predictable than other sectors, they can’t grow rapidly enough over a short period to overcome the effect of higher interest rates. As a result, their stock prices would decline.
  • Real Estate. Real estate investment trusts (REITs) also have bond-like attributes and are valued using a discount rate such as the yield on the 10-year U.S. Treasury. So, like a bond, an increase in rates would cause a decline in the value of REITs. In fact, a 1 percent increase in the discount rate would cause a 9 percent decline.
  • Banks. Banks, on the other hand, benefit when short-term rates rise as their spread— the difference between what banks pay savers and charge lenders—grows. Because of how their balance sheets work, even a 1 percent resulting from rising short-term rates would increase banks’ return significantly.

Conclusion

The upcoming increase in interest rates will affect your income, expenses, and net worth, but we don’t foresee a dramatic impact for most people. Our base case suggests an increase in short-term rates of between 1 and 2 percent. That’s enough to put the U.S. on a path toward normal interest rates, but not enough to frighten the stock or bond markets. We believe that the markets’ expectations for higher rates are priced in, but we acknowledge other risks, including geopolitical tensions abroad and at home, that could create volatility or cause a short-term pullback. As always, we recommend a diversified port term investment horizon as you work toward your financial goals.