Interest rates have been on a march upward since late 2015, rising from the extremely low level set during the 2008-2009 Great Recession. The U.S. Federal Reserve has indicated that rate hikes are likely through 2019, despite some unhappy rumblings from the White House. President Trump believes higher rates might put a damper on the robust economy and interfere with U.S. global competitiveness.
Despite his unhappiness, though, the head of the Fed, Jerome Powell, reiterated that climbing rates were likely at least through next year.
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Now, is it certain that rates will climb? No. In determining the direction of interest rates, the Fed aims to achieve its mission of making sure the economy doesn't overheat and of keeping inflation low. If future economic data indicate the mission could be achieved without rate hikes, the Fed's plans could change. But the most recent signals are that the Fed is holding steady with its longtime forecast of climbing rates in both 2018 and 2019.
The Fed usually changes interest rate direction very incrementally. Hikes of a quarter percentage point, for example, are common. As a result, major changes happen only over longer periods of time. There's thus likely no need to make sudden, major moves in an otherwise prudent retirement plan.
But there is a need to be aware of how the interest rate picture is changing and factor it into both your spending plans and the way you manage your investment portfolio. Let's look at why and how climbing rates can affect your retirement.
1. Adjustable-rate consumer debt becomes more expensive
When the Fed hikes interest rates, interest rates in banks and other financial institutions follow suit. Banks increase the interest rates they charge on adjustable-rate consumer debt, such as credit cards, car loans, mortgages, and personal loans.
If you have monthly credit card payments, the amount you pay will likely increase, because the annual percentage rate will rise. If you have an adjustable-rate mortgage, your payments are likely to jump when it resets.
The bottom line? It's a good idea to pay off credit card debt as quickly as you can in a rising-interest rate environment. It's also wise to lock in interest rates on mortgages at the lowest rate available before they subsequently rise.
2. Savings account yields rise
Banks and financial institutions also increase the interest rates they offer on savings accounts, money market accounts, and certificates of deposit (CDs) when interest rates move up. You should note, though, that the climb has not been as fast or as steep as that on adjustable-rate debt.
Savings account yields have been low for some time because of the low interest rates of the Great Recession era. Part of the Fed's mandate is to keep the economy on as even a keel as possible. When the economy goes into recession, as it did then, the Fed eases rates down to make borrowing more attractive, because borrowing can stimulate economic activity.
As a result, continually rising rates can make savings, money market, and CD accounts more attractive than they have been.
3. Bond yields rise
Bond yields also climb along with interest rates. Bond yields have been at historically low levels since the Great Recession as well, keeping pace with low interest rates. Not surprisingly, bond funds have not fared well with investors for the past decade.
For investors, rising bond yields may make bonds worth another look, especially if rates continue to climb throughout next year.
4. Bond prices fall
Ah, but if you're gazing with interest on bond funds because of the rising yield, be sure to look at the corollary: falling bond prices.
Bond yields and prices move inversely. Why? Well, bond prices are influenced by what investors are willing to bid for them, just like, say, housing prices are. If few people are interested, prices fall.
Let's look at an example. Say Bond X now yields 2%. Over the course of 2019, the Fed raises rates. Bond Y, yielding 4%, is then available for purchase. Bond X becomes very unattractive to investors because Bond Y, which yields more, is available. Bond X's price thus falls.
The key is that you need to be sure to factor in the likely direction of interest rates if you're thinking of bond fund investing.
5. Stock market sectors can be affected
Although rising interest rates don't have the same immediate and clear impact on the stock market as they do on the bond market, rising rates can affect some stock market sectors.
Banks and other financial institutions, for example, often do well, as they can charge more for their products.
Other sectors are affected more by the timing of the economic cycle. When the economy is robust, for example, durable consumer goods can benefit, because that's when consumers tend to purchase big-ticket items like cars or washing machines. But rising interest rates may also cause consumers to defer these purchases, because payments can be more expensive.
Many stock market investors don't pay much attention to interest rates. But it's essential to keep the interest rate environment in mind as one of many factors that can affect stock market performance.
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