The US Federal Reserve Open Market Committee raised interest rates again last week by a quarter of a percent. How will higher interest rates affect your investments? There are several ways that that higher rates will affect your portfolio both immediately and over the long term. Here are a few thoughts on the subject.
Immediate Effects of Higher Interest Rates on Your Investments
- U.S. Treasuries
- Corporate Bonds
- Dividend Stocks
U.S. Treasuries and Corporate Bonds
If you currently have U.S Treasuries, AA, or AAA corporate bonds in your investment portfolio, they just became a little less valuable when the Fed raised rates last week. And, if the Federal Reserve follows through with its projections and raises rates twice next year, these investment vehicles will become progressively less valuable. However, if you simply hold your bonds or Treasuries to maturity, you will not lose money on these investments. And, if you wait for higher rates, you will be able to purchase these bonds and treasuries and earn higher interest rates. Ideally, you will buy these when rates peak. Then you will be earning a good interest rate and your bonds or treasuries will become more valuable as rates start to fall.
Dividend stocks like utilities are often considered to be proxies for bonds. So, when rates go up but dividends do not, dividend stocks lose value. Providing that the basic business of the dividend stock does not change, such as with a utility, these investments will perform like bonds and Treasuries. But, if higher rates usher in a recession, many now-strong dividend stocks may take an earnings hit as well. Over the long haul the value of these investments will depend on their intrinsic stock value, in which case the effects of higher interest rates on the general economy will be important.
Longer Term Effects of Higher Interest Rates on Your Investments
CBS News writes that the U.S.’s interest payments are about to skyrocket. This is a big deal because it affects all sectors of the economy, government, and personal finances.
A recent Moody’s analysis noted that persistent high debt, among other factors, would lead to “persistent deterioration in the U.S.’s fiscal strength over the next 10 years.”
High federal borrowing could also crowd out other types of investment. The federal government borrows money by issuing treasuries; the investors who buy them are effectively lending to the government. A very high supply of treasuries could effectively starve other parts of the economy of investors’ money, some analysts say.
“If you issue more and more treasuries, the dollars you use to buy them need to come from somewhere. They could have gone into the stock market, or into other investments,” according to Torsten Slok, chief international economist at Deutsche Bank.
In the article they show a graph from the Office of Management and Budget showing the expected huge increase in payments on U.S. debt.
As the number of US dollar available for investment dwindles the US will not be the first country affected. Emerging markets are already suffering and there is the prospect of massive business failures in China this coming year. Despite Trump’s America First rhetoric, this is an interconnected world and trouble offshore will come back to bite the USA in the proverbial backside as well.
The US debt is already huge and due to the Trump tax cuts it is going to be a lot bigger. What is really worrying, however, is the size of the debt compared to the US gross domestic product, GDP. The game plan with recent tax cuts was that the resulting economic stimulus was going to raise GDP above 4%. That has not happened despite lower unemployment rates and, until now, a surging stock market. Many point to higher interest rates and their fallout as a reason that the stock market is getting bearish.
More Rate Hikes on the Horizon
Bloomberg writes that we are not going to see the death of rate hikes just yet.
Money markets appear to have completely nixed the idea of Federal Reserve interest-rate hikes in 2019, although the outlook may not be so simple.
As the Fed jacked up rates by a quarter of a percent in their most recent meeting, predictions of no more rate hikes seem to have been more wishful thinking than not.
The Fed is famous for thinking long term and is almost continually at odds with the short term political concerns of congress and the U.S. president. Too-low interest rates have an effecting of distorting markets. Real estate prices escalate because folks can buy more for their dollar due to the lower cost of servicing their debt. Investors tend to bid up stock prices and overheat the stock market. As Investopedia notes, the effect of interest rate changes can take up to a year to be felt.
Interest rates affect the economy by influencing stock and bond interest rates, consumer and business spending, inflation, and recessions. However, it is important to understand that there is generally a 12-month lag in the economy, meaning that it will take at least 12 months for the effects of any increase or decrease in interest rates to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term.
However, the stock market continually seeks to predict the course of the economy and the value of investments. And the stock market has been very volatile and in correction mode. How higher interest rates will affect your investments will be largely negative over the short term as rates go up and the costs of borrowing rise. Over the longer term the risk is tied to the drag on the US economy and US investor caused by an ever-increasing US debt burden as more and more of the results of US productivity are eating up by servicing the debt.
Is there a place to hide as this scenario plays itself out? If you like cash positions when the market is volatile, a smart move is to build a “ladder” of short term AA or AAA bonds or US Treasuries. A bank account is also protected by Federal Deposit Insurance. Then the issue is predicting a market bottom, providing that there is one as the long term effects of mounting US debt play out.