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The Fed’s Interest Rate Increase: Impact and Implications

By on January 8, 2016
Categories: D&Y UPDATES, MARKET NEWS

While news surrounding geopolitical and financial issues is by no means in short supply, the most significant financial headline of the fourth quarter was the U.S. Federal Reserve (the Fed) increasing the target federal funds rate for the first time in nearly a decade.  More specifically, the Fed’s policy-setting committee raised its benchmark interest rate, the interest rate at which a bank lends overnight funds maintained at the central bank to another depository institution, by a quarter of a percentage point from essentially zero.  Since the Fed adjusts interest rates to moderate the growth or contraction of the U.S. economy, this move signaled its belief that we have largely recovered from financial wounds suffered during the 2007-2009 financial crisis.  While signals of an improving economy are typically cheered by Wall Street, many investors continue to worry about the effects of current and future interest rate hikes.

Despite the rebound in stocks in the fourth quarter, the volatility that spanned much of 2015 contributed to the lackluster market performance we witnessed over the last year.  As the Fed was signalling confidence in the U.S. economy, global investors were closely monitoring developments surrounding the slowing Chinese economy and intensifying emerging market turmoil related to decreasing commodity prices and weakening currencies.

Asset class returns for the quarter and the year were as follows:

 

Index

Asset Class

Fourth

Quarter 2015

Full Year

2015

 Barclays U.S. Govt./Credit—Int.  Fixed Income         -0.7%

1.0%

 S&P 500  Large U.S. Stock

7.0%

1.4%

 Russell 2000  Small U.S. Stock

3.6%

       -4.4%
 MSCI ACWI ex-USA  Foreign Stock

3.2%

       -5.7%
 S&P Global REIT  Real Estate Securities

4.9%

       -0.4%

The recent rate hike by the Fed will almost certainly not be the last.  Understanding that rising interest rates will be part of the investment calculus for the foreseeable future, we think it worthwhile to highlight a few potential implications of this shift in U.S. monetary policy.

  • There is no need to rush large purchases as borrowing rates remain near historic lows.  While now is a good time to consider the possible impact of future rising rates on the purchase of a home or car, there is no need to feel rushed in order to save on financing.  The Fed determines the target rate for very short-term debt, but it has a less direct and more modest impact on rates for longer-term borrowing such as mortgages and car loans.  Although impossible to precisely predict, expectations regarding future interest rate fluctuations can best be summarized by the recent remarks of Federal Reserve Chair, Janet Yellen, who stated that the nominal federal funds rate is “currently low by historical standards and is likely to rise only gradually over time.”
  • Higher rates on savings accounts and money market funds are not immediately expected.  If you put money in a savings account or have certificates of deposit, you earned almost no interest over the last seven years.  Thanks to a savings glut that was initiated by the 2008 recession, banks are not currently competing for new deposits and are therefore slow to raise rates paid on savings accounts.  While America’s largest banks wasted no time in announcing that they would begin charging higher interest for loans following the Fed’s recent decision, they also made it clear that they did not have any immediate plans to increase interest rates associated with savings accounts.
  • The U.S. dollar may strengthen against global currencies.  Global currency markets may be in for a bumpy ride as the divergence between U.S. and foreign interest rates can be expected to strengthen the U.S. dollar.  More specifically, as investors find higher rates available in U.S. bonds, demand for the U.S. dollar may increase, further boosting the value of U.S. currency across global markets.  While this is great news for Americans travelling abroad, both U.S. companies that sell products overseas and emerging market borrowers with loans denominated in U.S. dollars will be adversely affected by increased dollar strength.

Given the comments above and the media attention surrounding the recent interest rate hike, it is reasonable to ask, “Why should I own bonds if we expect interest rates to continue increasing, and bond prices to naturally decline as a result?”  In response, it is worth re-emphasizing that the value of a fixed income allocation within an investment portfolio remains unchanged.  In well-functioning capital markets, today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, monetary policy, etc.  Accordingly, the possibility and expectation of rising rates is already factored into bond prices.

As proven time and again, no one can accurately and consistently predict short-term market performance.  Without knowing the exact timing and magnitude of interest rate changes, bonds still remain the critical “ballast” of our portfolios during times of stock market volatility.  Investing in high-quality, short-to-intermediate-term bonds allows investors to mitigate interest rate risk while simultaneously providing some portfolio income.

While the actions of the Fed have significant short-term implications for both the U.S. and global economy, our focus remains on the factors that most influence long-term investment success for our clients; i.e., managing portfolio risk, minimizing portfolio costs and taxes, diversification, and disciplined rebalancing in times of market volatility.

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