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John R. Deitrick, CFP®
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Should we be worried about higher interest rates?
Summary
- The Federal Reserve (Fed) raised interest rates by 0.25% this week and signaled they are on track for another two hikes in 2018.
- With the move of the Fed's benchmark rate to between 1.5% and 1.75%, the stock market staged a brief rally on the news of stronger economic growth, but worries of a slowing economy outweighed the move, sending the market lower.
- The new Fed Chair, Jerome Powell, confirmed he does not plan to deviate from the Fed's current slow and steady path of interest rate hikes.
It has become hard to find a "Wall Street expert" who doesn't think interest rates are rising in 2018 and beyond, so we thought it would be worthwhile to explore what this really means for investors. The Federal Reserve raised rates once in 2015, once in 2016 and three more times in 2017. Most forecasts we read currently call for a total of three rate increases in 2018, and the market seems to be focused on whether the Fed will raise rates a fourth time this year. We explore what it could mean if they do continue to raise rates - or raise them more than the market expects - to see if this is good or bad news for investors.
Why do interest rates matter?
The Fed currently tries to manage its monetary policy levers to achieve a predetermined inflation rate on the cost of spending on personal consumption. However, despite its best efforts during this recovery, inflation has failed to meet its target on a sustained basis. The reasons prices don't rise as much as the Fed desires are numerous, but one factor drives this phenomenon more than others: the ability and interest consumers have in buying goods made in the U.S. If the Fed feels the inflation rate is too low, they lower interest rates to make borrowing less expensive to drive demand for consumer goods. Alternatively, when the Fed believes inflation is climbing too high, they will raise interest rates to slow the economy down. Ultimately, these decisions drive the cost of borrowing money, impacting all sectors of the economy - from a person using a credit card to the federal government paying interest on the national debt. More importantly, investors often choose to invest in lower-risk but higher-yielding bonds when interest rates move higher, usually in lieu of buying stocks, which are perceived to be higher-risk investments.
Are higher interest rates good or bad?
In many respects, the answer to that question depends on how much money you borrow. The cost to borrow money - to finance a car, a house or a business - will be more expensive as rates move higher. However, bank accounts, CDs, and other debt instruments also pay higher rates to savers. Higher interest rates also tend to tame rising prices (i.e., inflation), so that tuition payment or the price of a new car doesn't move out of reach so quickly (well, perhaps not the tuition part). Banks also tend to lend more freely when rates are higher because they, too, pay less for the funds they receive. Finally, higher interest rates generally increase the value of a country's currency, increasing the demand for and value of that currency. As such, higher interest rates make the U.S. a more attractive option for foreign spending, which is good for tourism and selling U.S.-made products.
What is the downside to higher interest rates?
Higher rates slow economic growth, which impacts the profitability of businesses and can slow down hiring. However, the biggest impact is likely on the federal government. The Congressional Budget Office predicts that rising rates will triple the nation's interest costs over the next several years, from the current $269 billion to $818 billion. Interest payments will become the largest part of the federal budget, and will likely crowd out investments in infrastructure and education while hindering the government's ability to fund social welfare programs like Medicare and Social Security. In fact, it is not clear whether the government can afford to raise rates much more on its $20 trillion borrowings. Because the government now borrows to make its interest payments, just a 1% rise in interest rates increases the national debt by $200 billion. In fact, it's possible that at some point, despite the economic need for higher interest rates to cool an overheating economy, the Fed may face serious pressure to resist raising rates.
What else is driving rates?
Because our economy is so tightly linked to our global trading partners, the largest non-U.S. economies also play a role in driving U.S. interest rates. According to a recent study by the International Monetary Fund, corporate borrowing in China has reached unprecedented and unsustainable levels, rising to 165% of the country's GDP, which the report likens to the financial situation in the U.S. just before the financial crisis in 2008. The Chinese banking sector is currently the largest in the world - twice the size of the U.S. banking sector. If Chinese demand for local investments were to fall along with a decline in its banking sector, the U.S. economy would immediately feel the pressure as money flowed out of China and perhaps, seeking a safe haven, into the US.
As rates rise, what does it mean for my investments?
One common mistake investors make at the early stages of a rising rate environment is to eliminate all exposure to interest rates. Maintaining a diversified portfolio is important in all markets, and even more so in periods where the markets are transitioning from a declining to a rising rate environment. For some investors, shortening the duration (or weighted average time to maturity) and improving the credit quality of a portfolio can make sense in the early stages of a rising rate environment. More aggressive investors may consider high-yield bonds and emerging market debt - each of which can thrive when economic growth is accelerating. Treasuries and other government bonds also do well in slowing growth environments, while bank loans - another tempting sector due to their floating yields - add credit risk, which can suffer when the economy slows.
However, it's important to remember that the Fed's move to raise rates will eventually slow the economy, and these sectors can turn against investors quickly and violently. Rising rates usually coincide with strong economic activity, greater opportunity
and
higher overall returns. As such, they should not be a driver of major portfolio changes for investors with medium- to longer-term investment horizons.
This material is for informational purposes only and sets forth the views and opinions of our investment managers as of this date. The comments, opinions and estimates are based on or derived from publicly available information from sources that we believe to be reliable. This commentary is not intended as investment advice or an investment recommendation nor should it be construed as a solicitation to buy or sell securities.
This Thought of The Week has been prepared by and for Global Financial Private Capital, LLC ("GFPC"). GFPC owns all copyright rights in and to this and each of its Thought For The Week articles. It is impermissible to copy or redistribute GFPC's Thought For The Week articles without our prior approval.
Investment advisory services offered through Global Financial Private Capital, LLC. Securities offered through GF Investment Services, LLC. Member FINRA/SIPC. 501 North Cattlemen Road, Ste. 106, Sarasota, FL 34232
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I hope you find this information adds value. If you would like to talk to John regarding these, or any other financial concerns, please feel free to call us at (614) 602-6506 and we will be happy to schedule a visit.
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Investment advisory services offered through Global Financial Private Capital, LLC, an SEC Registered Investment Adviser. SEC registration does not imply any level of skill or training. Past performance is not indicative of future results. This commentary is not intended as investment advice or an investment recommendation it is solely the opinion of our investment managers at the time of writing. Nothing in this commentary should be considered as a solicitation to buy or sell securities. Insurance and Annuity product guarantees are subject to the claims-paying ability of the issuing company, and are not offered through Global Financial Private Capital.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and the federally registered CFP (with flame design) in the US., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
AssetLock® is tracking software used to monitor the performance of a client's portfolio, and to predetermine the amount of downside the client is willing to tolerate. It is NOT an actual stop order and will NOT automatically sell the individual securities in the portfolio. Therefore, the AssetLock® value is a reference point to encourage a conversation between the advisor/firm and the client to determine if the client's portfolio should remain unchanged, reset the AssetLock® percentage by reallocating to a different risk profile, liquidate part or all of their portfolio or opt out of AssetLock®.
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John R. Deitrick
CFP®
Advanced Retirement Design LLC.
7263 Sawmill Rd.
Suite 150
Dublin, OH 43016
Office: 614.602.6506
Fax: 614.259.6094
Email: jdeitrick@advancedretirementdesign.com
advancedretirementdesign.com
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