Interest rates are changing: Are your finances prepared?
May 22, 2013
It's been so unusual in recent years that it should be considered newsworthy on its own: Some interest rates have been rising lately.
However, it isn't just the level of interest rates that is changing -- the dynamics of the interest rate market have started to shift as well. In time, the combination of these developments could suggest a number of adjustments to your financial strategies.
A shifting yield spread
Long bond yields reacted to increased economic optimism in early May by rising sharply. However, short-term yields were not immediately impacted. This may reflect a consensus that economic improvement is coming, but that it is not coming especially quickly.
In any case, the important dynamic is not just that some interest rates rose, but that the spread between long-term and short-term rates widened. In April, the spread between 10-year and one-year U.S. Treasury yields was 1.64 percent. By May 17, this spread had widened to 1.81 percent.
If rates continue to rise and the yield spread continues to widen, there are a number of adjustments to your financial strategy that you should consider:
- Move toward longer CDs. The advantage of longer-term CD rates has all but disappeared in recent years, but if the yield spread continues to widen, expect this advantage to be restored. If interest rates are beginning to rise, it's probably too early to consider a major move into longer-term CDs, but as the yield spread widens, keep an eye on long-term CD rates. The ideal situation might be a gradual move into longer-term CDs, with an emphasis on CDs with relatively mild penalties for early withdrawals, as a hedge against a continued rise in interest rates.
- Upgrade your income investments. Investors have been forced to sacrifice quality for yield, but if Treasury rates continue to rise, you can start to move back to higher grade instruments while still getting a decent income yield.
- Consider a shorter-term mortgage. If the yield spread continues to widen, 15-year mortgages may develop a compelling rate advantage over 30-year loans. This may be a particularly appropriate strategy for refinancing if you already have significantly less than 30 years remaining on your mortgage.
- Ease back on stocks. Rising interest rates create a valuation headwind for stocks, as well as a more compelling alternative for investors. If interest rates continue to rise, it may be a good time to start to ease back on the equity percentage of your asset allocation.
- Take a fresh look at savings account rates. Rising interest rates should eventually affect savings account rates, but banks won't all react at the same time and to the same extent. When the market is in flux, it can be a good time to shop around for more attractive bank rates.
For the past few years, investors have seen little from interest rates except for a continued decline and a steady narrowing of the spread between long and short rates. So the recent rise in long rates and resulting widening of the spread is noteworthy. It is too early to tell whether this will prove to be a turning point for interest rates, but the longer that spread continues to widen, the more important the adjustments above will become.