The Good, Bad and the Ugly of Fed Rate Hike

It’s been almost ten years since the Federal Reserve has raised interest rates.  As the Fed cut rates in the aftermath of the Great Recession, retirees have suffered through historically low interest rates on savings instruments such as CDs, money market accounts and savings accounts.

What does this one-quarter percent rate hike mean for investors and consumers and what actions should you consider taking as a result?  The results fall into what I call the “Good, Bad & Ugly”:

First, it’s important to understand that raising the Fed funds rate .25% is far less important than how fast and how far the Fed will continue to raise rates.  A review of history suggests that once the Fed changes the direction of rates, it sets in place a multi-year trend.  In other words, expect rates to continue to rise over a number of years.  For example, the Fed lowered rates in Apr 2007 from 6.75% to 6.25%.  It continued to lower rates twelve more times until it hit a Fed funds rate of .0% in December of 2008.  Rates remained at that level until this past week’s rate hike of .25%.  This obviously was a very aggressive rate reduction policy and this time Fed Chairwoman Janet Yellen has indicated the Fed will be deliberate and conscious when raising future rates.

The Good

For savers, particularly retirees, you should see higher interest rates being paid on new bank CDs.  Unfortunately, I think many banks will be slow to raise interest rates on money market accounts and savings accounts as they seek to increase profit margins.  Higher rates will eventually come, but not right away.

What you should do now:  First, be aware that rates are trending up so be cautious about locking in rates for long periods of time.  For example, if you go ahead and lock in a 5-year CD for 2.25%, you may be unhappy when rates quickly rise above that level.  The same is true when buying individual bonds.  One strategy that might help off-set this negative result is using a laddering strategy.  For example, you could invest an equal amount of money in 5 CDs (or bonds) maturing years one through five.  That way, as interest rates rise, your bond maturing in one year can be reinvested at the new higher interest rate using a 5-year maturity.  This will allow you to ‘track’ interest rates as they rise.

The Bad

Many consumer loans are tied to what’s referred to as ‘bank prime lending rate’ which has been 3.25% for the past few years.  If you have a consumer loan tied to prime, your interest rate and payments will increase very soon…potentially as soon as your next payment cycle.  These can include personal bank loans, Home equity lines of credit (HELOCs), some car loans and adjustable rate mortgages as well as some student loans.  New loans, even those not tied to prime, are likely to demand higher rates.

What you should do now:  Review your existing loans to determine if they are fixed rate verses variable rate.  If variable rate, consider whether it would be advisable to convert it to a fixed rate even if that rate is higher than you are currently paying.  You might be better off paying a higher fixed rate now rather than allowing rising rates over the next few years climb much higher.  I can remember back in the eighties when the prime interest rate rose to 21%!

The Ugly

As interest rates rise, the values of existing bonds fall.  Nowhere will this be more apparent than with long maturity individual bonds and bond funds.  Over the past few years, investors have shifted to longer term bond funds or long-term bonds in an attempt to earn a decent rate of return on their money.  That worked out pretty well but with the rate trend now in a multi-year rising mode, these bondholders will likely face eroding values.

What you should do now:  Here I think you have two choices:

  • Swap out your bonds: Replace your longer term bonds and bond funds with bonds of shorter maturities. Good news: You may have a profit!

Hold your bonds: For individual bond holdings, you can choose to hold them until they mature and all you’ve lost is the opportunity cost on your money.  If you choose to hold longer maturity bond funds, you’ll need to plan to hold them until the rising interest rate cycle is completed (likely several years) and expect losses in your bond funds in the early years.  However, you should see the yields rise on these funds as the fund manager replaces maturing bonds with ones of higher yields.  My main caution with this strategy is that you avoid finding yourself in the position of having to sell bonds to raise money for cash flow.