The Federal Reserve (the Fed) announced in its December meeting that it will potentially be raising interest rates three times in 2022 to try to mitigate future inflation. Interest rates have been historically low in response to the COVID-19 pandemic, so investors should be prepared for how this may affect their stock portfolio, investments, and overall financial situation.
What happens when the Fed raises interest rates?
The Fed can only directly control the most short-term interest rate in the U.S. economy, the federal funds rate. This is the rate at which the Federal Reserve banks lend to other financial institutions overnight. Once this rate is increased, lending by other banks in the economy is affected, as their cost to borrow increases. This can effectively increase rates on longer-term interest rate products as well (mortgages, car loans, etc.).
In theory, this increase in rates should make businesses less likely to borrow money and consumers more likely to increase their savings. This marginal decrease in economic activity could be expected to slow down the economy and decrease inflation to a manageable level.
How do changes in interest rates affect your wealth management and financial planning?
Rates on cash will increase
Savings accounts have yielded close to 0% since 2020. As such, investors that are looking for higher returns could have considered other asset classes. Having a slightly higher yield on cash may nudge investors into reconsidering how they manage their portfolio and allocate their investments. You could still lose purchasing power if inflation is well above your interest rate.
Stock market returns cannot be predicted
We can look at history as a gauge to find out what happened last time the federal funds rate was on an upward trajectory. From 2015 to 2020, federal funds rate went from almost 0% to above 2%.
While the federal funds rate increased, stocks did experience volatility. However, even with a down year in 2018 the S&P 500 managed to return 73% from 2015 to 2020.
When the price of bonds decreases, your interest payments should rise
As interest rates increase, it is likely that bond prices will fall. If you hold these bonds to maturity though, you will receive the entire principal back and have the opportunity to invest in similar bonds with a higher interest rate. Looking at the total return of bonds (interest payments + capital appreciation) over the same period as above demonstrates that the change in interest rates led to a 16% return.
Debt from floating-rate notes should be evaluated
Have an adjustable-rate mortgage loan? A significant change in interest rates may lead to an unexpectedly high change in your payment depending on the benchmark interest rate, or reference rate, that is tied to your mortgage loan. If your payment is switching to an adjustable rate in the coming years, it might be worth weighing the pros and cons of refinancing to manage your cash flow and budgeting needs.
The same consideration goes for margin loans on your investments. These are typically based on the federal funds rate plus a fixed rate above that. Once the Fed starts raising rates, it is anticipated that your margin loan rate will increase as well. Starting 2022 by evaluating the amount of cash you have on margin, or within other debt instruments with variable rates, could be helpful in managing your expenses and savings.
The value of your pension lump-sum payout may decrease
One of the inputs for calculating the present value of your pension lump-sum payment is the interest rate. As this interest rate increases, the present value of your pension decreases. This means if you are considering a lump-sum payment of a pension in retirement, the amount you receive could be decreased (holding all else constant). You should consider this inverse relationship and evaluate your various payout options with your retirement advisor or tax consultant to see how they affect you from a tax and longevity perspective.
Protecting your money from inflation
Having an investment and financial plan that works in any interest rate environment is the best method for risk management and asset protection. At Columbia Pacific Wealth Management, we believe clients are often better served by having a diversified portfolio of protection and growth strategies, as described in our Diversification in Investing – Protection Against Market Volatility blog post.
As every individual’s financial situation is different, we encourage you to ask your financial advisor or contact a member of our wealth management team about how changes in interest rates might affect your portfolio and overall financial plan. You may also stay informed by reading our weekly updates, where we discuss the latest investment and wealth management trends and news investors should consider.
Important Disclosure Information:
Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. All opinions expressed herein are current only as of the date hereof and CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.