The long-awaited day of reckoning is here: The era of historically low interest rates is over.
At least that’s how investors have reacted to the statement from Federal Reserve Board Chairman Ben Bernanke on June 19 that “the downside risks to the outlook for the economy and the labor market have diminished.” Even though Bernanke also said there would be no immediate change in the central bank’s easy money policy, investors figured the moment is near for the Fed to start unwinding its efforts to support the economy.
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Investors had already begun bidding up rates in recent weeks, anticipating the Fed might signal a policy change, and continued doing so after Bernanke's announcement. The benchmark 10-year Treasury yield hit a low of 1.66 percent on May 2 and rose to 2.44 percent on June 21. The U.S. and global stock markets nosedived following Bernanke’s words, a fearful reaction amplified by worrisome signs that China’s economy is slowing. The Dow plunged 559 points in two days from its close on June 18, a drop of 3.6 percent.
So what do rising rates mean for you and your money?
In short, the higher interest-rate environment will benefit savers, be a mixed bag for investors and make loans and credit cards more expensive for borrowers.
Here’s my take on how you should be handling your finances as a result of the new economic environment:
The Outlook for Interest Rates
First, however, an interest-rate forecast. How fast and how far rates will actually go up is an open question, but the consensus is that U.S. Treasury yields and rates on credit cards, mortgages, auto loans and other consumer loans will rise slowly.
Moody’s Analytics predicts 10-year Treasury yields will go from today’s 2.44 percent to 3.5 percent in 2014 and to 4.5 percent by the end of 2015. James Paulson, chief investment strategist at Wells Capital Management, offers a similar forecast, looking for the 10-year bond yields to reach 4 percent in 2014.
The reason behind the expectation of a muted rate increase is that U.S. economic fundamentals are improving at a grinding pace. Unemployment is a steep 7.6 percent and the overall economy is growing by just 2 percent or so. Most important, inflation was merely 1.4 percent over the past 12 months.
“Interest rates won’t go up fast unless inflation goes up fast and inflation won’t go up fast with the economy as weak as it is,” says Meir Statman, professor of finance at Santa Clara University and author of What Investors Really Want.
That said, the unruly global credit markets represent the wild card in any interest-rate outlook. So don’t view any rate prediction as a sure thing.
Now for what this all means for you and how (or whether) to alter your finances accordingly:
Rising Rates and Savers
Let’s look at savers first. Bank savings accounts, certificates of deposit and Treasury bills have paid just a fraction of a percent over the past several years. Pretty chintzy.
You should enjoy slightly higher yields on these types of savings alternatives. But, at the moment, I wouldn’t lock up your money for too long.
For example, steer clear of one- to five-year CDs for now; their rates are still low (0.67 percent for one-year CDs and 1.23 percent for five-year CDs, according to Bankrate.com). You should be able to find higher-yielding CDs over the next year or two.
Rising Rates and Investors
The increase in interest rates, however, will hurt your investment portfolio if you currently own bonds or long-term bond mutual funds. When rates go up, prices of bonds and the net asset value of those funds go down (at least that’s the way it’s supposed to work).
Little wonder that over the two weeks ending June 12, investors pulled $24.4 billion out of bond funds, according to the Investment Company Institute, a trade group in Washington, D.C.
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It probably isn’t too late if you want to join that exodus, since you aren’t likely to take a loss. The actual rise in rates, so far, has been relatively small — less than one percentage point over the past month — despite all the turmoil in the bond market.
I think it makes sense now to reduce your exposure to long-term bonds to avoid potential losses. Park that money in shorter-term fixed income securities, like money market funds and bond funds.
Remember, bonds will become attractive again. If you wait a bit for rates to rise further then invest in bonds and bond funds, you’ll then be able to benefit from their higher yields.
Since no one really knows how high rates will go, a reasonable strategy could be to start dollar cost averaging: Put the same amount of money every month or at regular intervals into bonds or bond funds once they breach 3 percent or so. Currently, intermediate-term Treasury bond funds yield about 1 percent and long-term Treasury funds yield about 2.9 percent.
Incidentally, stocks are sensitive to the direction of interest rates, too. That’s why many Wall Street analysts expect the market to remain volatile until investors get a better handle on how high rates might go.
No one can pierce the fog of the investment future, of course, so in a turbulent time like this it’s smart to remember the basics when it comes to portfolio construction. “This is where the old adage about diversification matters,” Statman says. “You want to be well-diversified.”
Rising Rates and Borrowers
Now to what rising rates mean for you as a borrower. While the era of cheap money is over, look for rates on loans to climb gradually rather than soar. So don’t feel pressured to rush into taking on debt.
Expectations of higher rates will likely fuel home sales, but the increased demand will also boost the supply of houses on the market. As a result, a better balance between supply and demand should help dampen mortgage rate hikes.
The rate on 30-year fixed mortgages has already risen recently by more than half a percentage point, to 4.25 percent, and it’s unlikely that this rate will rise sharply.
Variable rate mortgages move up and down based on changes in short-term interest rates, typically U.S. Treasury bills. The Fed isn’t in any hurry to raise short-term rates, so rates on variable mortgages (currently 3.1 percent for a five-year ARM) won’t move up much.
This also means that if you’re considering refinancing, you might want to do so before interest rates increase. But you needn’t fear that delaying will cost you dearly.
Rates aren’t likely to shoot up quickly for car loans or other consumer loans, either. The auto industry is in no hurry to back off its financing deals and lose potential customers.
But nearly free car loans may disappear soon. My bank, for example, is offering auto loans with a rate as low as 0.89 percent. I expect that won’t last much longer.
Most credit cards have variable rates tied to other short-term rates; the national average card rate is 14.96 percent. So when short-term rates begin creeping up, you’ll see that on your credit card statement, too. (But you pay the balance off each month to avoid those outrageously high rates, right?)
Rising Rates and Retirement Savings
Finally, I don’t see higher rates derailing the improvement in the nation’s retirement savings, although the gains may slow.
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Thanks to a strong stock market, retirement account balances were 5 percent above their 2007 peak in the first quarter of 2013, according to the Urban Institute. And mutual fund behemoth Fidelity says the average balance in the 401(k) accounts it manages reached a record high of $80,900 at the end of the first quarter, a 75 percent gain from the market low.
On Wall Street, the shift from monetary easing to monetary tightening will be turbulent, sometimes scary. On Main Street, Americans have time to adjust their expectations to the new interest-rate environment.
I wouldn’t hurry to tweak savings and borrowing strategies, but I wouldn’t dawdle either. We’ve all been warned.