Financial markets always keep a wary eye on the Federal Reserve, but the scrutiny seems especially intense these days amid increasing signs that the Fed will raise interest rates in the months to come.
If you share this concern, you should think through the impact of a rate hike and make some financial moves now, rather than waiting for the Fed to take action.
The potential impact of higher rates
Any interest rate hike has the potential to be disruptive, but higher rates could be especially disruptive today because the Fed has not raised rates since 2006. This impact is likely to be wide-ranging, since interest rates have an impact on investments of virtually all types, as well as on the economy itself.
For example, interest rates are used as a discounting mechanism for stocks -- that is, they function as the denominator in stock valuation calculations. This means that if interest rates rise, stock valuations would fall unless earnings increase proportionately.
Earnings growth does tend to be the saving grace of these situations, since rate hikes generally take place in a strengthening economy. So, prices may take an immediate hit when rates are raised, but can recover subsequently as earnings growth comes around. According to The Economist, in the last seven rate-raising cycles, the stock market was shaky at the time the Fed raised rates, but in each case moved higher over the next six months.
Things are trickier when it comes to foreign stocks. A rate hike could add to the dollar's rally, effectively devaluing investments denominated in foreign currencies. The rising dollar also diminishes the value of foreign earnings, so U.S. companies that do a significant portion of their business outside the country could suffer as well.
As for bonds, their prices move inversely to interest rates, so rising rates would mean a drop in bond values. The negative impact might be cushioned by the fact that European bond yields are even lower than U.S. yields right now, which could fuel enough demand for U.S. bonds to support prices reasonably well.
On the positive side of the ledger, rising rates should boost bank rates. The only drawback is that with rates on savings accounts and other deposits starting from nearly zero, it may take some time for them to reach historically normal levels.
In terms of the economy, since rate cuts are meant to stimulate growth, it follows that rising rates tend to suppress it. However, the Fed hopes to be assured that growth is strong enough to withstand rising rates before it makes this policy change, and the benefit is that higher rates help keep a lid on inflation.
Perhaps the area of the economy to keep an especially close eye on is the housing market, which has been showing signs of fatigue anyway and could suffer even more if mortgage rates rise.
How to respond to rising rates
Since a rate hike entails some risk and uncertainty, you might want to make some financial decisions in anticipation. Here are five moves to consider:
1. Take gains in stocks. The S&P 500 has earned a return of 90.54 percent over the past five years. That strong performance makes this a good time to trim some of the big gainers from your portfolio rather than just letting everything ride.
2. Rein in foreign positions. Since a rising dollar puts foreign-denominated investments at a disadvantage, you might want to scale back the size of your foreign investments. While you are at it, you also might want to weed out any domestic companies that rely heavily on international sales.
3. Shorten up your bond portfolio. It will mean giving up some yield, but shortening bond maturities is the way to avoid heavy losses in a rising-rate environment.
4. Build a cash reserve. Given the dubious outlook for stocks and bonds, this might be a good time to build up your cash position a little. That cash reserve might also come in handy if you experience any financial setbacks should the economy slow as interest rates rise.
5. Take full advantage of low mortgage rates. Whether it is refinancing, switching from an adjustable to a fixed-rate mortgage or securing a home equity loan, if there is a move you have been contemplating to take advantage of low interest rates, now is the time to follow through.
While the timing of the next rate hike is uncertain, anticipation is vital. Waiting for the Fed to actually make the policy change might mean missing your opportunity to make a move before markets have already reacted.
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