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4 ways higher interest rates could benefit investors and consumers

July 20, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Higher interest rates for investors

One of the destabilizing influences on the stock market these days is speculation over when interest rates will start to rise. Conventional wisdom is that higher interest rates will be bad for stocks, but that assumption is worth challenging. There are a number of reasons to believe that higher interest rates could actually benefit stocks and the economy.

Why investors fear higher interest rates

Why do people think that higher interest rates will be bad for the stock market? There are a few reasons. For one thing, making it more expensive to borrow money could have a dampening effect on consumption. As it is, the economic recovery since the Great Recession has been marked by fits and starts. It is feared that higher borrowing costs could be the thing that tips the economy over the edge into recession.

From an investment standpoint, higher interest rates would enhance the attractiveness of alternatives to stocks such as bonds and savings accounts. This could draw enough money away from the stock market to weaken it. Interest rates are also explicitly built into many valuation models used for stocks, in a way that discounts future earnings by the prevailing interest rate. Effectively, interest rates are the denominator of this type of valuation equation, so that higher rates result in lower valuations.

4 big economic benefits of higher interest rates

Those negative views of the impact of higher interest rates are prevalent enough that the stock market has been prone to sudden declines when speculation about higher rates hits a peak. However, investors may be overlooking some potential positive impacts from higher rates, including these four benefits:

1. Potentially boost spending from interest earned

Americans with interest-earning savings and investments have suffered a devastating loss of income as a result of the plunge in interest rates started by the Great Recession. Take a representative example of a savings account if the interest rate dropped from 4.5 percent to 0.10 percent. On a $100,000 balance, this would cut annual interest income from $4,500 to $100. Restoring at least some of that lost income would put some much needed dollars back in the hands of consumers.

2. Economy may rely more on consumption, not debt

While low rates may have cut interest income, they are widely believed to help consumption by making it cheaper for people to borrow money. However, it is worth questioning whether encouraging higher debt levels is a good idea when many Americans are already overextended. Credit card debt did take a step back in the immediate aftermath of the last recession, but has been steadily rising since mid-2011. Non-mortgage consumer debt, including student and auto loans, took even less of a pause after the recession and has soared to record highs. The economy may be better off in the long run relying more on consumption from sources other than debt.

3. Higher rates could raise dollar-denominated investments

Higher U.S. interest rates would attract global investors to the dollar, raising the value of U.S. investments. Meanwhile, this would also benefit consumers by making imports cheaper.

4. Increased attraction to dollar may solidify its global status

Besides benefiting U.S. investments and purchasing power, attracting money to the U.S. dollar would reinforce its status as the dominant global currency. It is estimated that the majority of global economic output is generated in currencies that are linked to or influenced by the dollar, but some world leaders have begun to advocate finding alternatives to the dollar. Losing its status as the world's primary currency could make it more difficult for the U.S. to borrow money, which would have dire consequence for a country carrying such a large national debt.

Concerns about the possible adverse effect of higher interest rates are not necessarily wrong. It's just that conditions are complicated enough that there could be enough positive implications alongside the negatives to balance out the impact of higher bank rates.

Comment: How do you expect your investments to be impacted by higher interest rates?

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