This photo provided by Northern Trust shows chief investment strategist Jim McDonald. McDonald explains what he expects to happen with interest rates, how that will impact financial markets, and what investors should, or shouldn’t do. (Bill Meyer, Northern Trust via AP)

This photo provided by Northern Trust shows chief investment strategist Jim McDonald. McDonald explains what he expects to happen with interest rates, how that will impact financial markets, and what investors should, or shouldn’t do. (Bill Meyer, ... Northern Trust via AP) (The Associated Press)

Q&A: What to expect from the Federal Reserve on rates and how financial markets may react

Economic Indicators Associated Press

This month's Federal Reserve policy meeting could signal the end of an era.

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Policymakers may decide to raise interest rates for the first time since the Great Recession, marking the end of an era of ultra-low rates that has defined financial markets for almost seven years.

Although signs of slowing global economic growth have decreased the likelihood of a September rate increase, many economists still expect policymakers to take action at least once this year as the labor market improves. The Fed has kept its benchmark rate at close to zero since late 2008 to help revive the economy.

As well as helping the economy, those low rates have been great for financial markets.

The Standard & Poor's 500 index has almost tripled since bottoming in March 2009, as corporate profits have surged. Bond prices have also climbed, pushing down yields. In turn, that has boosted demand for other dividend-rich securities, such as high-yield bonds and real estate investment trusts.

But if interest rates start rising, will that automatically reverse the stock market's momentum?

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Jim McDonald, chief investment strategist at asset manager Northern Trust, explains what he expects to happen with interest rates, how that will impact financial markets, and what investors should, or shouldn't do.

Fed policymakers will meet Sept. 16 and 17.

Q: Do you expect an interest rate increase this year?

A: We do expect a rate increase this year. The Fed is itching to start to get off zero interest rates, so they will move this year.

They are nervous that they don't have any dry powder to deal with an increase in financial markets or economic volatility. They can't really cut rates any more and the market would respond negatively to (more) quantitative easing. They want to get rates up, so that in the future, if they want to cut rates, they have that option.

Q: How high could interest rates go?

A: Over the next year, it could be two interest rate hikes. So, they would get up to 50 basis points (0.5 percent) and then they have to hang out. Because along with the Bank of England they will be the only central bank that is raising rates. The economy is just not that strong.

Q: What should investors do in response to higher rates?

A: There is absolutely no need for panic around the Fed starting to raise rates. Some people are concerned about it, but this an extremely studied event and the market is rarely disrupted by an event that is over analyzed. And this has been over analyzed.

The recent volatility in the market has been tied to China. And, secondarily it's been tied to people saying "jeez, you know what? The major central banks really don't have a lot of ammo if we do get into a significant downturn." It's that aspect of monetary policy that has been of concern. It's not worries about a 25 basis point increase, which, in the scope of everything else going on, is immaterial.

Q: So investors shouldn't overreact?

A: It's a "let's ride this out" situation because raising interest rates is generally tied to the economy improving, and the economy is going to have to be doing OK for the Fed to raise rates. The history of the stock market is that it does fine when the Fed starts to raise rates, because the Fed taking action is corroboration that the economy is strong.

Q: Which sectors perform best in a rising rate environment?

A: Typically the financials would be the stand out performer in that environment. Financial stocks have been hurt by the low interest rate environment and they should be good performers with a higher rate environment. So they are the number one example. But we're not overweight financial stocks right now because we think that the rate increases are going to be relatively minor.

Q: What's your favorite sector in the current environment?

A: We're focused more on the fundamental background of the different businesses. Health care is one of our top recommendations and that's because the fundamentals in health care are just so good. And they won't really be impacted by a small increase in interest rates.

There's been a significant increase in volumes across the industry tied to the Affordable Care Act. That's been good news for health care providers.

Q: What about bonds?

A: We don't expect a major upset in the bond market tied to a Fed rate increase. Expectations are already built into the market. We think that the longer maturity bonds will be particularly well behaved when the Fed starts to raise rates. That's because the bond investors will worry that the Fed is going to slow economic growth.

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Answers edited for clarity and length.