Federal Reserve Rate Hike: What Does it Mean?

The events of the past week bring one word to mind: finally. Last Wednesday, the Federal Reserve (Fed) finally raised the target for the federal funds rate by 0.25%. By raising this key overnight borrowing rate, the Fed raised interest rates for the first time in nine years—an event that has been receiving a great deal of attention recently. Surrounding the past several Fed meetings, there has been much talk of “will they” or “won’t they.” Leading up to this meeting, the Fed implied it would raise rates, and the market was expecting it.

file000821289525However, until the announcement was made today, a degree of uncertainty remained. So, what does this really mean? It means the potential for key rates to tick up, such as mortgage or credit card rates. Most bonds have “priced in the hike,” but some could still feel a slight negative impact. However, overall, we should take this as a positive sign. We have not experienced a rate hike in nine years, and, perhaps more importantly, we have not had rates above the 0–25 basis point range (0–0.25%) since late 2008.

The Fed said it would only raise rates if the economic data signaled a healthy economy. We have seen strong numbers posted over the past few months, and the Fed affirmed today it believes this trend should continue. To sum up, the Fed has raised rates because it believes the economy is strong and likely to continue to grow without the added support of near zero interest rates.

For the market, this is potentially a positive event. Yet, rate hikes also reaffirm that we are in the mid-to-late stage of the economic cycle. In this part of the cycle, we can expect additional market volatility. We especially anticipate it in the coming weeks and months, as investors become comfortable with the “new routine” for U.S. monetary policy.

Although we have just experienced the first raise, many will immediately start thinking about what’s next. The debate will continue regarding how fast the Fed will raise rates, how far it will raise them, and when it will stop. Today, the Fed’s own projections put the fed funds rate at 140 basis points (1.4%) a year from now, while the fed funds futures market puts the fed funds rate at just 80 basis points (0.80%) by year-end 2016.

arrowThis difference implies a gap between what the Fed says it will do and what the market thinks the Fed will do. How this gap is resolved will play a key role in the future direction of financial markets, particularly fixed income markets. Luckily, Fed Chair Janet Yellen is aware that markets will continue to debate what may lie ahead. Her comments during the post-meeting press conference suggest the Fed will continue to proceed cautiously, taking into consideration the impact of rising rates on consumer spending, the housing market, business capital spending, the value of the dollar, and overseas economies and financial markets.

A slow path for further increases will give the economy and markets time to adjust to the changes. It has been a long time since we last saw the Fed hike rates. It does feel unusual, but also positive, and hopefully this change is well worth the wait. It means that we are returning to a more typical economic environment, which is a welcome change from the atypical environment we have lived in since the Great Recession.

And even though this is a big change in Fed policy, what shouldn’t change is our commitment to the long-term investment plan that is ultimately our blueprint for success. As always, if you have any questions, I encourage you to email me at bill.pollak@lpl.com or at (925) 464-7057.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Economic forecasts set forth may not develop as predicted.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond and bond mutual fund values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

This research material has been prepared by LPL Financial.

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Should You Worry about a Federal Reserve Interest Rate Hike?

After years of record-low interest rates, at some point this year the Federal Reserve is expected to begin raising its target federal funds interest rate (the rate at which banks lend to one another funds they’ve deposited at the Fed). Because bond prices typically fall when interest rates rise, any rate hike is likely to affect the value of bond investments.

bond-investingHowever, higher rates aren’t all bad news. For those who have been diligent about saving and/or have kept a substantial portion of their portfolios in cash alternatives, higher rates could be a boon. For example, higher rates could mean that savings accounts and CDs are likely to do better at providing income than they have in recent years.

Also, bonds don’t respond uniformly to interest rate changes. The differences, or spreads, between the yields of various types of debt can mean that some bonds may be under- or overvalued compared to others. Depending on your risk tolerance and time horizon, there are many ways to adjust a bond portfolio to help cope with rising interest rates. However, don’t forget that a bond’s total return is a combination of its yield and any changes in its price; bonds seeking to achieve higher yields typically involve a higher degree of risk.

Finally, some troubled economies overseas have been forced to lower interest rates on their sovereign bonds in an attempt to provide economic stimulus. Lower rates abroad have the potential to make U.S. debt, particularly Treasury securities (whose timely payment of interest and principal is backed by the full faith and credit of the U.S. Treasury), even more attractive to foreign investors. Though past performance is no guarantee of future results, that’s what happened during much of 2014. Increased demand abroad might help provide some support for bonds denominated in U.S. dollars.

Remember that bonds are subject not only to interest rate risk but also to inflation risk, market risk, and credit risk; a bond sold prior to maturity may be worth more or less than its original value. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.