The good news is that, chances are, your investments grew in 2017. And while there are no clear signs that the economy is slowing down, the reality is that it doesn’t mean your portfolio will perform as well this year. As we continue into 2018, a new tax bill and a government shutdown will undoubtedly have unique financial repercussions on each one of us.
What will also impact us is the Federal Reserve’s announcement last December that it will raise the benchmark fed funds rate between 1.25% and 1.5%. The decision is not necessarily a bad thing. It can be assumed that the Fed is confident the economy could handle an increase in the cost of borrowing money (read the Fed’s release.)
The increased fed funds rate – the rate banks charge each other to borrow money overnight – unto itself does not impact your portfolio. What does impact your portfolio is the strong influence the rate hike has on interest rates. This directly impacts your financial wellbeing, including your investment portfolio.
Relationship between Fed fund rate, inflation, and interest rates
Industry experts like us at Miramontes Capital believe the Federal Open Market Committee’s (FOMC) decision is the first of several Fed rate hikes to transpire in 2018. Designed to raise the inflation rate, currently at 1.8% as of mid-January, it had yet to reach 2 percent, a rate that the FOMC estimates is ideal for the economy.
Since banks use the fed funds rate to determine the prime rate – the rate banks charge their best customers – any adjustment impacts the interest rates on credit cards, bank loans, mortgages and deposits. Like any ecosystem, rising interest rates could impact the market for bonds.
How rising interest rates affect your portfolio
Interest rate movements are notoriously hard to predict. Regardless of your portfolio mix, you should have a working understanding of how higher interest rates can impact your investments.
Savings and CD interest
Contrary to what seems would result from a .25% increase in the fed funds rate, savings interest rates do not increase as much as you would think. While they do follow a similar pattern – when the Fed raises rates, savings rates also tend to rise and vice versa – interest rates don’t generally move up as much as loan interest rates. For example, despite the Fed decision to raise rates by 75 basis points over the previous two years, the greatest outcome for consumers was a rate increase of five measly basis points from 36-month CDs. Hardly an investor’s desired yield.
To understand the relationship between fixed-rate bonds and interest rates, imagine a seesaw. When market interest rates are high, fixed-rate bonds prices are low. The opposite is similarly true: when market interest rates are low, the fixed-rate bond price is price. Bonds with shorter maturity dates – the specific date in the future when the face value of the bond will be repaid to the investor – generally have lower interest rate risk than bonds with longer maturities. That’s because there’s less time for the bond’s value to be affected by changing interest rates prior to maturity as opposed to bonds with a longer maturity date.
Keep in mind that rising interest rates (or decreasing interest rates for that matter) will not affect the income you receive. Meaning, if you hold onto the bond until it matures, you will be paid the stated interest rate. If you do need to sell your bond when rates go up, the value of the bond may have gone down, which means you would sell at a loss.
Rising interest rates have a complicated relationship with the stock market. On one hand, rising interest rates are a positive sign for investors in that bigger company profits mean better performing stocks. Companies that thrive during a booming economy are often the same ones that increase dividends.
On the other hand, there are also negative effects on rising rates. When interest rates rise, companies pay more to borrow money. Higher borrowing costs make for shrinking profit margins. In addition, since stocks are seen as riskier investments than bonds, investors may be more inclined to sell their stocks and invest in assets that guarantee a rate of return upon maturity.
Stay the course of diversification
The best remedy for managing your portfolio when interest rates are rising is to reduce your risk. You can only accomplish this through diversification, which means building a well-balanced portfolio with a broad range of investment. It does not mean that you won’t experience losses, but it puts you in a much better position to contend with unforeseen market fluctuations.
Miramontes Capital is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Miramontes Capital and its representatives are properly licensed or exempt from licensure. This blog is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Miramontes Capital unless a client service agreement is in place.