Interest rates play a crucial role in the American economic system. They influence the return on savings, the costs of borrowing and can have a bearing on the direction of many investments. The direction of interest rates is also known to provide insight into future economic and financial market activities.
After the Federal Reserve’s August 2021 meeting, Fed Chairman Jerome Powell stated that, should hiring numbers continue to improve, it will begin dialing back the ultra-low interest rate policies that were put in place to help stave off the effects of the pandemic-induced recession.
Here are a few major areas that interest rates could have a positive or negative impact:
Historically, we are still seeing very low mortgage rates, however, an increase in interest rates could convince some potential home purchasers to push the pause button. Home prices are still high, and if interest rates increase, this double whammy may have many homebuyers deciding to stay put until the prospect of a better time to purchase a home arises.
A rise in interest rates could be favorable for savings account and certificate of deposits (CDs) holders. While rates are still very low, if interest rates rise, the yields on these accounts typically increase.
With the economy continuing to strengthen and unemployment numbers decreasing, most Fed officials are expecting the Fed to reduce bond purchases this year. What exactly does this mean for bond holders and purchasers?
As you many know, bond and interest rates move in the opposite direction. When interest rates rise, existing bond prices tend to fall, and conversely, when interest rates decline, existing bond prices tend to rise. As interest rates rise, new bond yields are likely to change.
Yield is a straightforward concept. It is the current income return you receive when, for instance, you own a bond, as measured by a percentage. If the bond you bought for $1,000 pays you $30 per year — that’s a 3% annual yield.
For example, if you invest $10,000 in a 10-year U.S. Treasury bond with a 3% yield, that interest rate is fixed even as prevailing interest rates change with economic conditions—especially the rate of inflation. Let’s say after five years you decide to sell that bond, but interest rates have risen and now similar new bonds are paying 4%. Obviously, no one wants to pay $10,000 for a bond yielding 3% when a higher-yielding bond costs the same. Therefore, the bond’s value will decrease.
Bonds are many times considered a good option for a conservative, balanced portfolio. Although they could provide modest returns, many high-grade bonds are usually considered more stable than stocks and can provide income. However, investors who put a high percentage of their portfolios in bonds with the hopes of producing stable returns, could see lackluster results if interest rates rise.
Converse to bonds, interest rates don’t directly affect stocks. They can, however, indirectly affect stock prices. When interest rates rise, banks increase their rates for consumer and business loans. Reduced consumer and business spending could lower the value of a stock. When interest rates are increased, this usually means that there is economic growth or strengthening.
Portfolios that are well balanced, diversified, and planned to weather volatility should be well positioned to face rising interest rates.
In summary, when interest rates rise, the following usually happens:
- Mortgage rates increase
- Interest rates increase on savings accounts and CDs
- Existing bond prices decrease
- Commodity prices decrease
- Equity markets may become more volatile
Since each individual has different financial goals, interest rate fluctuations can affect investors differently. Having a solid financial plan, sticking to that plan, and working with a financial professional before making any decisions to sway from that plan is always advised.
Interest rates can be complex. As mentioned earlier, we keep a watchful eye on interest rates and how they may affect our clients. In today’s interest rate environment, we are monitoring your investments with us. If you have any questions or would like us to review your specific situation, please let us know.
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