With interest rates inching upward in the U.S. and elsewhere following a period of sustained low rates, what should investors do to maximize their earnings?
Last month, the Federal Reserve raised interest rates and signaled it will raise interest rates more this year. This followed a raise in December, the first in more than a year.
Interest rates can impact all types of investments, from savings accounts to certificates of deposits, to investment grade equities, to high quality debt, to junk bonds.
Market Reaction Uncertain
When interest rates rise, the price of bonds drops, according to Investopedia. Many analysts predicted that falling bond prices would cause equities to lose value. This, however, has not been the case. Equity values have not suffered on account of the rising interest rates to date.
But this does not mean the situation won’t change, especially with further rate hikes planned.
The stock market’s strength has been driven by expectations that the Trump administration will increase spending and lower taxes.
But when stock markets react to political and economic events, stock market corrections often follow.
Hence, it’s not hard to see that in the present climate, uncertainties exist for stock values. Investors are advised to consult with professionals on investing and not act on impulse, regardless of their bonds and equities mix.
More Rate Hikes To Come
In December, The Fed voted to raise the federal funds rate by 0.25% to a target 0.5 to 0.75%. Stock prices did not change, giving investors a signal not to change investment strategy.
However, the Federal Open Market Committee, the Fed’s interest rate setting panel, indicated there will be three rate hikes in each of the next three years, marking a faster pace of hikes than it previously indicated.
The target range could be as high as 2.75% to 3.00% by the end of 2019.
Since the range was 0.00% to 0.25% through December 2015, the change could be seen as dramatic.
Impact On Banks
The key policy rate applies to lending between banks out of the reserves they hold at the Fed. It does not impact non-bank borrowing directly, but it does affect it indirectly.
The federal funds rate represents the cost that depository institutions pay for borrowing from Federal Reserve banks. It is the rate the Fed uses to control inflation. By increasing this rate, the Fed shrinks the supply of money available for financial activity by making money more expensive.
The federal funds rate determines the prime lending rate, the rate commercial banks charge their most creditworthy customers. The prime rate is the basis for credit card rates, mortgage rates and other loan rates.
Following the Fed rate change, every major bank said they would raise their prime lending rates from 3.5% to 3.75%.
Savings And Money Market Accounts
Banks also pay depositors higher borrowing costs. Hence, a savings or money market account that only pays a few dollars a year will pay more.
Banks profit from the spread between their lending rates and their borrowing rates, and they have little incentive to pay more on deposits and reduce their profits. But deposit rates are still likely to rise on account of competition among banks.
A small number of banks have recently raised rates for savers, according to Forbes. These increases are not great, but they are moving in the right direction. The best rates are offered by online banks, small banks and credit unions.
Banks have been more willing to raise rates on certificates of deposit, according to depositaccounts.com.
Due to the length of time it takes for banks to raise rates on deposits, they will incur better profits, and their investors will share in these gains. Bank of America’s stock rose 2.9% in a two-day period in December. JPMorgan’s rose 1.9%.
Impact On Corporate Profits And Stocks
The impact of the federal funds rate on the stock market is not direct. But there is an indirect effect.
Since they have to pay more to borrow money, banks increase the rate they charge their customers to borrow money. This results in higher mortgage and credit card rates, particularly those loans carrying variable interest rates. This reduces the amount of money for consumers to spend. When paying bills becomes more costly, there is less disposable income, which impacts companies’ revenues and profits.
Businesses also borrow from banks. When businesses have to pay more for money, they often choose to borrow less money, which in turn slows their growth. This can hurt earnings, causing a decline in stock prices.
If a company cuts back on investing, its estimated future cash flows will decline, which lowers the price of its stock.
Should a large number of companies suffer declining stock prices, the market indexes such as the S&P 500 and Dow Jones Industrial Average decline.
Investors do not get as much stock price appreciation when stock values decline.
Financial Stocks And T-bills
The financial sector, however, often benefits from interest rate hikes. Banks, insurance companies, brokerage houses and mortgage companies often earn more since they can charge more for lending.
Interest rates also impact bond prices and returns for T-bonds, T-bills and certificates of deposit. As interest rates rise, bond prices fall.
The longer the bond’s maturity, the more it fluctuates in relation to the interest rate.
When the federal funds rate rises, new government securities like bonds and T-bills are seen as safe investments and post an increase in interest rates. The “risk free” return rate increases, making such investments more attractive.
When the risk-free rate rises, the return needed for investing in stocks also increases. If the required risk premium falls while the potential return decreases, investors are likely to see stocks as risks and will invest elsewhere.
Impact On Bonds
Businesses and governments often raise funds through bond sales. When interest rates rise, so does the cost of borrowing. The demand for lower-yield bonds falls, bringing their price down with them.
Jeffrey Gundlach, DoubleLine Capital chief investment officer, noted the Fed tightening corresponded to a gain in 10-year Treasury yields. These could reach 4% in the next year. A sell-off in government debt could drive a bear bond market, which began following Trump’s election victory.
Gundlach said equities could also suffer. A 10-year Treasury above 3% calls into question certain aspects of the stock market.
Since bond prices correlate to the federal funds rate, the tightening indicates a bond rout, especially with trillions in government bonds being bid up to trading with negative yields.
Further Impact On Stocks
Changes in interest rates also affect investor psychology. When the Fed announces a rate increase, businesses and consumers oftentimes cut spending, which can cause earnings and stock values to decline.
But expected actions do not always materialize.
The economy’s condition can also affect the market’s reaction. When the economy weakens, a slight decrease in interest rates may not be enough to offset weak economic activity, causing a decline in stocks to continue. Conversely, near the end of a strong economy, when the Fed increases rates, certain sectors could continue to do well, such as entertainment and technology stocks.
While the relationship between the stock market and interest rates is indirect, they tend to move in opposite directions. When the Fed raises interest rates, stocks as a whole decline, but there is no guarantee how the market reacts to a given interest rate change.
In 2013, both the S&P 500 and interest rates rose significantly, defying conventional wisdom.
Financial advisors cannot predict the stock market and its reaction to interest rate hikes. But they can advise clients to try to benefit from higher interest rates while taking into account all possible risks.
If a client has a 60/40 mix of equities and fixed income investments like bonds in a declining interest rate environment, for example, it could make sense to reverse the mix and have 60% in fixed income and 40% in equity to take advantage of higher bond prices.
Better Yields On Higher Quality Debt?
Nearly a decade of low interest rates has forced many investors to buy lower rated bonds from riskier firms in order to get a reasonable yield, pushing up prices, according to Barrons. Rising interest rates will make yields on higher-quality debt more attractive—and could result in a selloff in the lower-rated areas of the market as investors bolt riskier bonds.
Wells Fargo Securities recommended that investment grade buyers focus on higher quality debt. The bank distributed a list of trade ideas to help investors navigate through the transition. It noted that the difference in yield premiums between ratings categories like single-A and double-A is small, so investors won’t give up a lot of value. In some cases, yields could be higher even on higher-rated bonds.
For example, a 2021 bond from Lowe’s, the home improvement chain, carried single-A-minus ratings and yielded 2.49% recently. In contrast, a 2021 bond from Apple with a double-A-plus rating yielded 2.51%, according to Wells Fargo. A triple-B-minus 2022 Molson Coors Brewing bond yielded 2.94%, compared to a single-A-minus rated Anheuser-Busch 2022 bond at 3.01%.
Such trades help investors buffer against possible spikes in volatility by rotating back toward more defensive portfolios, Wells Fargo analysts wrote.
For those with a stomach to take on more risk and buy high-yield bonds, the same strategy can apply. Portfolio managers at Brandywine Global Investment Management recommended higher quality junk bonds, such as those with single-B and double-B ratings. Such bonds offer a lower risk of default than triple-C-rated debt and are easier to trade. Investors can quit their positions without assuming major losses if there’s market turmoil.
In a rising interest rate environment, higher quality junk bonds perform well, according to Brian Kloss, a Brandywine Global portfolio manager.
Some investors say the best way to deal with the accelerating pace of Fed rate increases is to stay flexible. Portfolio managers at Eaton Vance Management favored corporate bonds from emerging market countries since they offer attractive pricing and insulate investors from interest rate risks in the U.S.
The Dollar Strengthens
When higher interest rates make investing in safe, dollar denominated assets like Treasuries attractive, capital flows in from other countries, especially the emerging markets, according to Investopedia. The dollar then gains against foreign currencies, impacting trade.
The Fed’s hike also drove the dollar up against the yuan. China is the third largest US. trading partner. The dollar’s strength makes U.S. exports more expensive, putting the squeeze on the manufacturing sector.
Foreign Exchange Strategies
Changes in interest rates can affect strategies for exchanging foreign currencies for domestic currency.
If one U.S. dollar equals $1.35 Canadian dollars, it is not a good time to exchange Canadian money into U.S. dollars since the Canadian dollar will only be worth 0.65 U.S dollar. It would, however, be a good time for Americans to invest in Canadian currency when the U.S. dollar is stronger than the Canadian dollar.
When investing in foreign currency, investors still should buy low and sell high. The U.S. dollar currently equals 0.94 Euros.
Rising interest rates can strengthen the domestic currency, but they do not always. The last time the Fed raised interest rates, the U.S. dollar rose while the most recent rate hike was followed by a fall.
Long Or Short Term Investing?
When investing for the long term, investors must put aside short-term changes. If their portfolio asset mix matches investment objectives and some level of risk can be tolerated, there is no need to buy and sell frequently.
It is never smart to try to “time the market,” especially during uncertain political periods.
The Federal Reserve isn’t the only central bank raising interest rates, according to The Street.
On Thursday, Mexico’s central bank raised its benchmark interest rate for the fifth meeting in a row, increasing rates by 25 basis points to 6.50%. The increase signals confidence in the Mexican peso that has rebounded thanks, in part, to a softening of anxieties over the Trump administration’s positions on Mexico.
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