RISING INTEREST RATES AND YOUR PERSONAL ECONOMY

What a year it has been so far. The rapid rise of inflation has caused the Federal Reserve (Fed) to use its tools to push interest rates up to combat inflation. To be clear, the Fed does not set interest rates. Rather it has a strong influence on the short end of the yield curve. The Fed has many tools to work with, its primary tools for interest rate movement include:

1. Setting the Discount Rate – this is the interest rate the Fed charges banks that borrow funds directly from the Fed. Banks rarely borrow directly from the Fed to meet their reserve requirements. The Fed is known as the lender of last resort. Instead, a bank will borrow overnight from other banks who have excess reserves. Interestingly, the interest rate banks charge each other for overnight loans is called the Fed Funds rate. The Discount Rate has a strong influence on the Fed Funds rate.

2. Setting the IORB Rate – this is the rate of Interest On Reserve Balances the Fed pays to banks on their excess reserves.

Together these two short-term interest rates have a strong influence on all other short-term rates such as the Treasury Bill rate and the LIBOR (London Interbank Offer Rate) which are used as a base for many commercial loans. Longer term rates are determined by market forces. When you hear LIBOR plus 3, such as in a new mortgage or the re-set of the interest rate of an adjustable mortgage, that means a loan is being offered at the current LIBOR rate, plus 3%. These are competitive rates, meaning you may be able to get a similar loan at another bank for LIBOR plus 2.875. These market forces are based on supply and demand.

Investors of bonds collectively determine what rates they demand to earn on their investment depending on the credit term and quality. When the market is demanding higher interest rates for longer term investments, this means it believes interest rates will be higher in the future. In this scenario, we would have an upward sloping yield curve which is normal. Let’s say you are an investor holding a 30-year bond that has 20 years remaining before maturity and a 3.5% coupon rate. If the market for 20-year bonds is at 4%, then virtually no one would buy your bond at par. To make this transaction the price of your bond would have to be discounted (reduced) so that its yield to maturity was at the prevailing market price. These market conditions are what causes the price of bonds to fluctuate. In a rising interest rate environment, long term bonds take more of a price decrease to be fairly valued or competitive with existing or newly issued bonds.

The Fed’s Influence

As you can see, the Fed can influence interest rates although it does not set interest rates, especially at the longer end of the yield curve. Why would the Fed want interest rates to rise? Normally this occurs when the economy is overheated. Interest rates have an impact on the overall economy. If the Fed believes the economy is too hot it will cool it down to prevent asset bubbles, such as in the housing market that popped in 2008 – 2009 which caused the Global Financial Crises. What we are experiencing now is 40+ year high rate of inflation. The classic definition of inflation is too many dollars chasing too few goods. When interest rates rise, this normally will slow the demand for goods and services. In addition to the two tools mentioned above to influence the rise in short-term interest rates, the Fed is also decreasing the money supply. This is being accomplished by reducing its balance sheet. When the Fed sells bonds from its balance sheet the market purchases drain money out of circulation.

Stocks and bonds compete for investors. The volatility (price movement) is normally much lower for bonds than for stocks. If a current stock investor can get a high-quality much safer bond yielding 6%, its much more tempting to sell a volatile stock with and an expected long-term return of 8%. and purchase a smoother ride with a bond that is yielding 6%. The investor is accepting a much lower risk security for a decent safer return.

We have been in an extraordinary low interest rate environment for a long period of time. Many have criticized the Fed for overheating the stock market with these very low interest rates which have pushed investors into higher yielding stocks. With this change in monetary policy many investors will be happy to increase their investment allocation back into bonds to decrease the overall volatility of their portfolios if they can get an acceptable yield.

What Does This Mean To My Personal Economy?

This depends on your primary needs and goals. Following are the basic categories of needs and the impact of rising interest rates:

Borrower - If you want to borrow money it will cost more to do so with higher rates. Shorter-term loans such as auto loans and credit card balances are usually tied to short-term rates such as the Treasury Bill (1-year of less) or LIBOR rates. Longer-term loans like home mortgages and student loans are often tied to the 10-year Treasury Bond rate. If you already have a fixed rate loan it will not change as the market interest rates increase. Whereas, if you have a floating rate loan such as an adjustable-rate mortgage, the higher interest rates will go in effect at the next re-set period.

Non-borrower - Rising rates typically impact more than just borrowers. The housing market normally cools in periods of rising rates. This is because from a cash flow standpoint it is more challenging for some buyers to afford a mortgage on a potential new house because the monthly mortgage payments will be larger with the higher interest rate.

Lender – when you have cash on deposit at a bank, CDs, or bonds in your portfolio you are a lender. If you have a floating rate product such as a money market account, the interest you receive will increase in a rising rate environment. Your fixed rate products such as CD’s will continue to pay the current rate until maturity, then as you reinvest the proceeds you will obtain the higher rate. When you own a marketable bond the price of the bond will decrease so that its yield is competitive with the higher rates available in the market. If you hold this bond until maturity, you will only experience a paper loss (not a realized loss). Upon the bond’s maturity you will receive its par value. The distinction between a bond and a bond fund (collection of bonds selected by the fund’s manager) is a bond matures, whereas the bond fund does not. This is because the bond manager can sell and buy specific bonds within the bond fund’s portfolio. When a bond held within the bond fund matures, the fund receives par for this security, normally the manager will replace the matured bond with a new bond. In a rising rate environment, the new bond has a higher yield than the one it replaced. What we typically see with bond funds is they initially go down in value in a rising rate environment and in time as higher yielding bonds are added to the portfolio, its yield will increase. As a long-term investor you may experience paper losses at first, before you are paid the higher level of interest later. There is a lag effect for bond funds. Bonds are an important component to most investors’ portfolios because of they are typically less volatile to equities. The combination of these two low-corelated asset classes provides the investor with diversification which can smooth out the journey for long term investors.

Investor – when you invest in equites (stocks) changes in interest rates can impact the value of your holdings in an indirect manner. The companies you are purchasing when you buy stocks typically needs access to capital for research and development and other business expansion needs. In its simplest form this capital can be obtained by bank loans or by issuing bonds. In a rising rate environment, the cost of capital for these companies is now more expensive which can decrease its earnings and ability to pay dividends. What a stock investor is really buying is a slice of the company with the expectation of increases future earnings. Companies that achieve higher earnings or the ability to pay higher dividends typically will see more demand for their stock, i.e., the stock price will increase. High quality companies with lower debt are better positioned to weather a rising rate environment. Smaller growth companies along with tech companies with high capital needs will find a rising interest rate environment more difficult. This creates buying opportunities for long-term investors who can handle higher volatility in stock prices in the short-term.

The bottom line for rising interest rates – this depends on whether you are a borrower, lender, or investor along with your risk tolerance and your investment time horizon. Some investors see this environment as a buying opportunity. If you need funds in the near future for large, planned expenses, you will want to preserve this portion of your capital with conservative investments. If you are focused on your long-term goals, then dollar cost averaging through this volatile period should serve you well in the future. The markets get spooked by uncertainty. The Fed is trying to cool an overheated economy coupled with high inflation to a soft landing. We have been here before and will most likely see this again. A diversified portfolio suited to your needs is normally the best way to go. Trying to time the market means you have to get it right twice, which is nearly impossible.