Federal Chairman Ben Bernanke recently announced that the economy is looking healthy. He also stated that the Fed will likely begin to wind down its Quantitative Easing (QE) program by the end of the year if the economy continues to grow at its expected pace. After his announcement rates started to rise and bond prices fell.
When interest rates rise it has substantial impact on individuals and the economy, as well as the investment world. Increasing interest rates can lead to inflation, reduced investment and lower confidence among individuals and investors. An increase in the interest rate impacts the value of stocks, bonds, real estate, the dollar and gold.
Bonds and other fixed-income securities are sensitive to interest rate changes. When interest rates rise, the prices of bonds generally fall, as evidenced with Bernanke’s announcement. Not all bonds are created equal, however. Long-term bonds lose more value than short- term bonds, and bonds with low coupon rates may suffer a bit more than similar bonds with higher coupon rates. Investors who hold bonds until maturity get back the face value of the bond (usually $1,000), no matter which way interest rates may move (assuming the issuer does not default). Investors who sell their bond before maturity could get back more or less than face value, depending on what has happened to interest rates and the price of the bond.
To protect against rising rates, review the portfolio and asset allocation of your clients. The key is to create a mix of fixed income investments that can help your client weather a period of rising rates — or potentially even prosper from them.
The Fed also said it plans to keep short-term rates – money markets, auto loans and credit cards – as low as possible until 2015, maybe even 2016. Short-term rates are supposed to benefit the economy by making credit cheap for companies and encouraging investment. The government said it will keep its own “federal funds” rate — the rate it charges commercial banks for short-term loans — at or near zero, which allows banks to lend money at slightly higher (but still low) rates and still make a profit.
Stocks tend to rise when investors think the economy and corporate earnings will grow. When the Fed increases rates, it may restrain the economy. When interest rates go up, people and companies that borrow money pay more. People are often discouraged from borrowing for big ticket items like cars and homes.
Mortgage rates have inched up. According to Forbes, “In the week ending June 6, 2013, the 30-year fixed rate mortgage clocked 3.91% in its fifth consecutive weekly gain, according to Freddie Mac, after hitting its highest level in a year last week. That’s 18% higher than the 3.31% record low set in November of 2012 and almost 17% higher than the 3.35% rate logged in the beginning of May. The 15-year fixed rate broke above 3% as well, to 3.03%. Compared to a month ago, the increase translates roughly into an extra $30 per month for every $100,000 of debt accrued. If rates continue their upward march, mortgages will become more expensive.”
Could this potentially mean a slowdown in buying and refinancing? Most likely.