Last week, stock indexes posted some of the biggest daily losses since the spring. One explanation for this volatility was an increase in current and projected interest rates. If you’re wondering why many market watchers are predicting higher rates, look no further than the testimony of Federal Reserve Chairman Jerome Powell.
Last month, Powell announced that the Fed would most likely reduce its purchases of Treasury bonds and other debt later this year. In addition, starting next year, the Fed may increase the key federal funds rate, which will affect short-term interest rates throughout the economy. The Fed would take these steps as there are signs that recent inflation in our economy may continue. If we do anticipate higher interest rates in the future, consider these potential impacts that could affect your financial situation.
Higher interest rates could reduce the appreciation of stocks, especially growth stocks. Over the past five years, we have seen incredible returns for large corporate growth stocks. According to Morningstar, this category has appreciated more than 23% on an annualized basis over the past five years. Growth stocks are generally defined as those priced relatively high by the stock market relative to their book value (called book value) or earnings. The price of growth stocks is higher because the market expects high earnings growth in the future. When interest rates rise, the projected earnings of growth stocks are worth comparatively less, which could dampen their annual returns.
Bonds lose value but pay higher rates. The image we try to convey to our investment students is the see-saw relationship between interest rates and bond prices. As interest rates rise, bond prices tend to fall. This happens because bond prices have to adjust to offer a competitive offer in the secondary market.
Imagine a ten-year bond issued today with an interest rate of 2.4%. If you buy this bond for $ 1,000, the issuing company will pay you $ 24 a year in interest and then pay you back your principal after ten years. If the market interest rate for these bonds later increases by an additional 2%, then the prices of the existing bonds must fall to compete with the new offerings. The bond price may need to drop from $ 1,000 to $ 860 to be competitive. Savers would still get the same $ 24 in interest per year, but then rely on their bond worth $ 1,000 when it matures as part of the total return.
You can estimate your exposure to interest rate increases by looking at the duration of a bond (or bond fund or ETF) expressed in years. A blended intermediate bond index can have a term of 6 years, which means that if interest rates increased by 2%, we would expect the bond’s price to lose 12% of its value. If you expect interest rates to rise, you may want to focus on short-term bonds or cash in your current portfolio which will tend to depreciate less than long-term bonds.
Rising interest rates wouldn’t always be bad news. We would finally see a shift towards rewarding savers. Retirees and others who depend on interest payments have been one of the victims of our low interest rate environment. Many would benefit from CDs and online savings interest rates exceeding a fraction of 1%.
Borrow as much as you can at current rates. If we are heading for higher interest rates, it makes sense for borrowers to lock in rates today while they can. Bankrate currently shows conventional thirty year mortgages available with rates below 3% and no starting point. If you plan to own your current home or investment property for more than a year or two, it might be a good idea to refinance your mortgage. If you are concerned about one-time refinancing expenses given your expected property schedule, you can always ask for a slightly higher rate that will cover some, if not all, of the upfront costs. With true “no-cost” refinancing, if you even improve your current mortgage rate by a quarter of a percent, it could be worth it.
David Gardner is a Certified Professional Financial Planner with Mercer Advisors, practicing in Boulder County. The opinions expressed by the author are his own and are not intended to serve as specific financial, accounting or tax advice. They reflect the judgment of the author on the date of publication and are subject to change.