3 Reasons to Rejoice Higher Interest Rates
Interest rates are going up. The Federal Reserve has essentially said so. They just haven’t said exactly when or by how much. Are you afraid of higher interest rates? If so, what you fear is probably the potential bad side. While they may have a dampening effect, there also are some silver linings to be found.
Most news articles about higher rates focus on the negative aspects: They may corrode the economy and the financial markets, increase mortgage interest payments and other consumer borrowing costs, decrease spending, increase the value of the dollar (which can make US exports less competitive), hurt business confidence and depress capital spending, increase government debt interest payments and lead to higher taxes. Have I missed anything?
Fears vs. Realities
Let’s look past the potential doom and gloom and assess the facts. On June 17, 2015, the Federal Reserve Open Market Committee (FOMC) reaffirmed an Effective Federal Funds Rate of between 0% and 0.25%, according to Chair Yellen’s FOMC Press Conference Opening Statement. They also are considering the first increase later this year, with a potential rate increase to about 1.75% in late 2016 and 2.75% in late 2017.
These are not big increases. They only nudge rates to where they should be given the low, 2% inflation rate that the Fed is also predicting. Should they even occur, I believe these increases will have a negligible effect on the economy and on financial markets.
Moreover, what’s left out of most interest rate discussions are the silver-lining benefits from higher rates. I see at least three of them.
A Great Anxiety Is Lifted
When I ask advisors about the number one question they’ve had to address during the past six years since the credit crisis, it’s overwhelmingly been the “certainty” of higher interest rates and what to do about them. Across the country if not the world, this conversation has probably occurred at least a billion times since rates collapsed, and that could be a gross understatement.
The worry and confusion about what may occur when the Fed raises rates has been a huge distraction from the business of investing. This will go away once rates increase. If the economy and the markets do not collapse, and I don’t expect they will, it will be a heavy weight removed. Perhaps advisors can then get back to more constructive conversations about bonds, and how they can help control risk in a long-term investment portfolio.
Many Investors Will Earn More Money
When the Fed dropped interest rates to near 0% to stem the credit crisis, many retirees faced not having enough income to make ends meet. The Wall Street Journal reported on how the Fed's Low Interest Rates Crack Retirees' Nest Eggs, and Bankrate.com listed 6 ways the Federal Reserve and its low interest rates are hurting retirees. Making do in a low-interest-rate environment is still nerve-wracking for those living on a fixed income.
When interest rates go up, the net result should put more money in the pockets of these investors. That’s a good thing. Interest rates on Certificates of Deposit and new bond fund investments go up, and the total return on bond funds held in long-term saving accounts should eventually increase too. These are positives for investors on fixed incomes. Not enough articles point this out.
Allan Roth of Wealth Logic recently published a Wall Street Journal post, How to Get Ready for Rising Interest Rates. Citing Vanguard data as the source for his analysis, Roth included a table featuring the total return of an intermediate-term bond index fund given various rate-increase scenarios across 10 years. The fund starts with a 2.3% yield and 5.6-year duration. Figure 1 illustrates selected data from Roth’s table.
Figure 1: Total return of an intermediate-term bond fund when rates rise in one year.
Source: Vanguard data cited by Allan Roth, figure by Portfolio Solutions®
There is a severe drop in principal when interest rates increase significantly in one year. This is no fun for bond investors. However, after four years, the annualized total return is positive for all except a 4.0% rate jump, and after seven years the total return in all higher interest rate scenarios is greater than if rates had not increased. Since the annualized compounded rate of return is higher after 10 years than if rates did not go up, an increase in rates is additive to an investor's net worth.
In my view, the fear of short-term principal loss due to higher rates overshadows the benefit from higher returns in the long-term. Investors with horizons of five years or more should focus on the benefit of higher total return rather than the temporary inconvenience of a short-term principal loss.
The Fed Gets Its Hammer Back
The Federal Reserve Act states a dual mandate to promote maximum employment and price stability. One way the Fed attempts to achieve these mandates is through interest rate policy.
Using various tools, the FOMC can directly and indirectly influence interest rates across the yield curve. One way the Fed controls short-term rates is by setting the discount rate. This is the interest rate charged by Federal Reserve Banks to depository institutions on short-term loans. A second way it controls rates is through open market operations, which involves buying and selling government securities that influence market rates.
The Fed is constrained in how they can conduct monetary policy when short-term interest rates are at or near their current 0%. An increase in short-term rates returns a big money-managing hammer to the Fed and allows the FOMC to normalize rate policy. If inflation or unemployment increase beyond the Fed’s targets, it can attempt to knock them back down by reversing policy and lowering rates.
A Glass-Half-Full Outlook on Risking Interest Rates
Yes, odds are high that interest rates – at least short-term rates – are going up. If you feel anxiety about this, think of the good news that higher rates can bring. There are benefits to interest rate increases, even if not enough of us in the financial press are talking about them.