By Mitchell Lamoriello | Research Analyst | 10.16.2018
What are the most consequential forces impacting the U.S. economy today? People are probably wondering just how far this year’s tax cuts can propel the expansion, or maybe they’re worried that tariffs and trade issues could bring everything to a halt. The third candidate, for those paying attention, would probably be the steady upward march in interest rates.
Rates do not exactly have the same headline-grabbing quality as trillion-dollar tax cuts or trade wars. If you’re not shopping for a mortgage, following Federal Reserve (Fed) policy or trading bonds, then it’s easy to not notice. But rising interest rates could eventually have a profound cooling effect on a hot economy.
Here’s a quick status update: The Fed increased its benchmark funds rate in late September—its eighth rate hike of this cycle—and is expected to do so again in December. There will likely be a few more increases in 2019 if the economy keeps humming along. The Fed funds rate now stands at about the same level as summer 2008, right before the banking system seized in the wake of Lehman Brothers’ bankruptcy. Of course, rates were headed lower then, and they’re headed higher now.
If rising rates are powerful enough to slow or even reverse the course of an economic expansion, then it stands to reason that they can also have a significant impact on our personal financial lives. Here’s a look at how higher rates can alter the factors that we use to calculate our decisions and expectations.
Investments | Affluent investors don’t necessarily need heavy exposure to aggressive investments in pursuit of high potential returns. In many cases, it’s more important to preserve wealth with an emphasis on slow-and-steady growth or income. It so happens that these lower-risk investments also have a strong relationship with interest-rate trends.
Income-oriented investments—Treasuries, high-quality corporate and municipal bonds, dividend-paying stocks, and others—are highly sensitive to interest-rate movements. They tend to perform better when rates are falling (because they offer comparably higher yields than new lower-rate investments), and worse when rates are rising (because they offer comparably lower yields than new higher-rate investments).
This doesn’t mean that higher-quality income-oriented investments should be avoided just because rates are rising, but it helps to understand how they might perform in this environment. Also, challenging periods for high-quality bonds usually look a whole lot calmer than bad periods for stocks. And the good news is that investors can re-invest their income and new money for higher yields as rates increase.
Financing | It almost goes without saying that the environment for borrowers becomes less hospitable when interest rates increase. That’s exactly why the Fed uses rates as a blunt tool for modulating the pace of economic growth. A sluggish economy can be propelled by low borrowing costs, and a red-hot economy can be restrained by high borrowing costs.
At a personal financial level, this has a few implications with varying degrees of severity. First, there’s an added benefit to retaining older fixed-rate financing that was issued at lower rates, including mortgages. The new tax law’s caps on mortgage-interest deduction will impact exactly how all of the decision-making factors align, but generally it’s fair to say that higher rates reduce the incentive to increase your borrowing costs.
Businesses and investment properties that can cover their borrowing costs may be less sensitive to the impact of rising rates. At the very least, however, higher interest payments represent a greater risk in financing any investment decision. That fact is most apparent in the context of investing on margin. Taking out a loan to fund investments in financial markets is a risky proposition in even the most accommodative environments. As rising rates increase the return required to offset margin costs, the risk-versus-reward balance moves quickly out of your favor.
To sum it all up, it’s generally better to be a lender or investor than a borrower when rates are rising. Even so, affluent investors should have a thorough understanding of how rising rates impact higher-quality income-producing investments. Expect less from these asset classes while rates are rising, and then expect more once they’re finished rising.
If you still have questions or concerns regarding this topic, reach out to our retirement plan team experts—we would be happy to help.