In an effort to slow higher inflation, the Federal Reserve, the nation’s central bank, is expected to raise interest rates this year. Analysts expect at least three rate increases, with the first quarter-point rate hike possibly coming at March’s Fed meeting.
How could the Fed interest rate hike affect you? That can depend on whether you are an investor, a borrower, a lender or a consumer – higher interest rates can have a range of effects. On balance, though, higher interest rates can work in your favor – if you have a plan in place.
- You may see a better return on your cash reserves.
- Borrowers could face higher interest rates on debt.
- Some asset classes may perform better in a rising rate environment – that’s why we help you build a diversified portfolio.
Fed rate hike history
Since the Covid-19 crisis began, the Fed has kept its benchmark rate (the federal funds rate) exceptionally low – in fact, close to zero. The last (and only other) time the Fed kept interest rates so low was in response to the global financial crisis of 2007-2009. Historically, the target federal funds rate is somewhere between 2% and 5%, so this gradual return to “business as usual” really comes as no surprise.
Why are interest rates rising?
The reason the Fed lowers rates during a crisis is to stimulate the economy back to growth by making it less expensive to borrow and spend money. And the reverse is true: The Fed will begin to increase rates when it aims to slow down unchecked growth.
Since the Covid-19 pandemic, we’ve experienced lower-than-normal interest rates. Christopher Jones, our chief investment officer, stated in an article on Money.com that “the cost of borrowing – whether that’s student loans, mortgages, car loans or even, to some extent, credit cards – has been substantially cheaper than is the historic norm for some time now.”
With GDP growth and the labor market strong and inflation high, the Fed will aim to keep the economy moving along at the optimal rate. Jones echoed, “the Fed has made it pretty clear that the days of zero interest rates are numbered.”
Borrowers beware, savers rejoice
Higher interest rates impact many areas of the economy and consumer finance in different ways. Anyone borrowing money this year – whether it is an individual applying for a credit card or a corporation taking out a significant loan to help fund research and development – may end up paying a higher rate on the borrowed amount.
On the other hand, income-starved savers stand to see better yields on their cash reserves – whether those are in savings or checking accounts, certificates of deposit or money market accounts. Savings or money market accounts, according to the FDIC, offer savers only 0.06% or 0.07% in interest, respectively, while a 12-month CD yields just 0.13%. So, despite the risk that higher inflation poses to savings, higher rates will be welcome news.
What do higher rates mean for investments?
Higher interest rates can have a range of effects on investment markets. For example, rumors of Fed actions can affect the behavior of markets. We saw this in January 2022, when uncertainty about how aggressive the Fed might be led to a volatile month for markets. But this is a short-term, psychological effect – where traders try to account for future Fed moves.
In the longer term, though, higher rates can affect stocks and bonds in more substantive ways. For example, some companies may find it more expensive to do business – so their future growth may slow down, which can impact the stock price. Other companies – like banks – may benefit from higher rates.
The bond market is historically even more sensitive to interest rate increases. Why is this? Bonds are issued with a certain rate attached – it is a promise to repay the purchaser after a certain amount of time, at that rate.
So, in a rising interest rate environment, the rate on a bond may suddenly seem less appealing when there will soon be new bonds available that offer a higher rate. That is why the market prices of bonds tend to drop when the Fed announces rate hikes – especially for short- or medium-term bonds. Moreover, those bond market prices react to expectations about Fed rate hikes. By the time the Fed changes rates, it is typically too late to adjust your bond portfolio to avoid the price changes.
Overall, different types of investments react in different ways to changes in interest rates. That is why we implement a diversified investment strategy for all our clients. You may have heard us explain our approach in this way: “Own it all, all the time,” so that you do not have too much of your wealth concentrated in just one area of the market.
How to prepare for higher rates
Rising interest rates won’t affect every aspect of your financial life in the same way. But there are a few steps you can take now to help make sure you are positioned for any benefit:
- Build your cash reserves. If you do not have the recommended amount of cash reserves on hand (three to 24 months of expenses, depending on how stable your income is), now is the time to take advantage of any higher rates that may be offered this year.
- Pay down high-interest debt. Especially if you have variable-rate loans or credit card debt, try to reduce the outstanding amount before the increases kick in. Lock in low rates on loans and refinance mortgages whenever possible.
- Keep your portfolio diversified. Stocks and bonds, as well as other types of investments, will react in different ways to a rising rate environment. That is why we implement a diversified investment approach for you that includes a wide variety of asset classes and market segments.
- Don’t be reactive, be proactive. “Try to make sure that you are coming into it in the right way and remove as much emotion from it as possible,” says Andy Smith, executive director of financial planning at Edelman Financial Engines.
If you have questions about rising interest rates or are interested in a diversified portfolio approach, contact an Edelman Financial Engines advisor.
Investing strategies, such as asset allocation, diversification or rebalancing, do not assure or guarantee better performance and cannot eliminate the risk of investment losses. All investments have inherent risks, including loss of principal. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Past performance does not guarantee future results.