Hold on to your hats, interest rates are going up, and that has consequences for all investors. The Federal Reserve‘s Open Market Committee has made no secret of its plans to increase the federal funds rate.
That key monetary policy tool is the interest rate Federal Reserve banks charge each other for short-term loans. Several factors, including inflation and employment rates, influence the fed funds rate. The Fed increases the rate when it needs to temper an overheating economy and high inflation, and reduces the rate to spur economic growth.
After dropping rates to near zero to combat the 2008-2009 recession, the Fed has been steadily raising rates to normal levels. In 2017, there were three 0.25 percent rate hikes that together increased the current fed funds rate to 1.5 percent. This year, three more rate increases are predicted, creating the potential for pain or gain depending on what you invest in. These four types of investments especially may be sensitive to rate increases.
[See: 7 ETFs to Buy as Interest Rates Rise.]
Real estate. Mortgage rates are quick to respond to interest rate hikes, hurting real estate investments as their financing costs rise. For example, as the Fed began raising rates, the Vanguard Real Estate exchange-traded fund (ticker: VNQ) fell 22.35 percent. From a July 2015 high of $92.45, VNQ recently traded at $75.56.
Not all the blame for the performance of real estate investments can be laid at the Fed’s door; the overall economy also plays a big role. “As the economy expands, rents and property values increase as well,” says Chris Johnson, senior wealth advisor at the Colony Group.
Although real estate investment trusts tend to suffer when rates first begin rising, REITs generally recover long term to post big gains from higher rates. “For example, according to the FTSE NAREIT Equity REIT Index in 1999, REITs sold off 13 percent during a rate increase period and then recovered with a 21 percent return over the following one-year period,” Johnson says.
The correlation between the fed funds rate and REIT returns is imperfect. In 2006, when the fed funds rate was 4.29 percent, up from 1 percent just two years earlier, REITs still had a banner year, returning 35.07 percent.
Stocks. Companies looking to borrow and expand their businesses face higher borrowing costs when the Fed raises rates. Johnson says this can drive stock prices down because higher borrowing costs lower corporate profit margins.
As interest rates rise, companies might borrow and pay more to do so, or they might postpone their plans to expand. If so, a higher fed funds rate could hurt investors by slowing the pace of economic growth and subsequently the overall return from stocks, says Richard Muskus Jr., president of Patriot Bank, N.A.
Higher interest rates don’t always cause a decline in stock prices. Interest rates are only one of many contributing factors to stock market prices, Johnson says. In the early 1980s, the fed funds rate bounced around from 9.03 percent in July 1980 to a stratospheric 17.82 percent in August 1981 and back down to 8.51 percent in February 1983. Yet, the stock market returned 33.15 percent in 1980 and suffered a 4.15 percent loss in 1981 before rebounding handsomely with 20.50 and 22.66 percent returns in 1982 and 1983, respectively, making for an inconclusive correlation with the fed funds rate. What’s more, although the fed funds rate was high during that period, inflation dropped from 12.52 percent in 1980 to 3.79 percent in 1983.
[See: 9 ETFs for Nervous Investors.]
Bonds. As interest rates rise, bond prices fall. If an investor can get a higher bond return from new bonds in the market, then existing bonds, which have lower yields, must be priced at a discount to compete with new issues. Typically, bonds with longer durations decline more than shorter-term issues as interest rates rise. Bond markets are already jittery over rising rates, with some experts declaring that bonds are in a bear market now.
Mark Heppenstall, CIO at Penn Mutual Asset Management, holds a bearish near-term view on U.S. Treasury bonds, although his longer-term view is more optimistic. Heppenstall thinks the fed funds rate won’t surpass 3 percent long term, and once rate increases stop, bond investors should be rewarded with stable bond prices. In general, in a rising rate environment, new bond investors are better off buying short-term bonds, which have shorter periods until maturity.
Eventually, though, the higher fed funds rate will force bonds to pay investors more, giving bond owners higher, juicier yields.
Meanwhile, the jury is still out on returns for high-yield corporate bonds. Aggressive yield-seeking investors could find somewhat higher returns from these bonds as the Fed raises rates, but the data is conflicting. For example, from 2013 through 2017 the fed funds rate hovered near zero, but during that time high-yield corporate bond returns were up and down. In 2013, these bonds returned 4.54 percent while the fed funds rate hovered around 0.14 percent. Then in 2016, returns jumped to 11.21 percent despite a fed funds rate notching up slightly higher to 0.34 percent.
Cash. Banks and money market funds are slow to raise interest rates on savings accounts after the Fed makes its move. Despite several rate hikes last year, the Federal Deposit Insurance Corp. still reports low average interest rates for these accounts. As of early March, the interest for savings accounts averaged 0.07 percent nationally, and money market accounts paid a paltry 0.10 percent. CD rates weren’t much higher with one-year average rates at 0.32 percent and five-year rates at 0.93 percent.
Eventually, savers will see higher rates. As the fed funds rate rose from 1.24 percent in 2003 to 5.29 percent in 2007, cash returns followed closely. Average cash returns, including those for CDs and money market accounts, returned 1.02 percent on average in 2003 and rose to 4.67 percent in 2008 after the fed rate hit 5.29 percent.
[See: 9 Ways to Invest in America With Bond Funds.]
As CDs, savings accounts and U.S. Treasurys become more attractive, they could hurt returns for other investments. When interest rates were ultra low, there was no real investment alternative to stocks because returns for bonds and cash were dismal, says Ian Winer, managing director and co-head of equities at Wedbush Securities. With rising rates, he says, “we are in uncharted territory.” He thinks REIT returns could fall as risk-free government bonds and CDs become more attractive, with stocks potentially faltering for the same reason.
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Why the Federal Funds Rate Matters to Investors originally appeared on usnews.com
