After almost a decade of record low interest rates, over the last 24 months the US Federal Reserve has been incrementally increasing rates. The US Fed is charged with helping maintain inflation targets as well as contributing to economic stability. They primarily do this by use of their control over the money supply as well as influence over nationwide interest rates through various operation.
The regular cycle of interest rates includes supporting the economy by reducing rates during economic downturns and increasing the money supply simultaneously. The theory is that this will encourage consumers, businesses, and even the government to spend more freely as the cost of borrowing is significantly reduced. Similarly when the economy achieves a sustainable growth rate in the economic cycle the Federal Reserve begins to increase rates and reduce the money supply. This is done to remove the artificial assistance that had been provided to the economy with the desire to limit inflation threats and achieve stable economic growth.
With that said, fluctuations in rates often have drastic economic effects. Increasing interest rates can result in a reduction in risk taking or capital expenditures by consumers and businesses alike. As an example, lets consider a business was considering a $100 million real estate development and was looking at a 5% interest rate on bonds or loans that is now looking at 7% rates for the same project. This is directly costing that business $2 million per year extra interest on that project. The economic case for such a project becomes a lot tighter.
On the other hand, lenders of money have suffered for the last decade due to low rates. Lenders of money don't just include big banks, but include any person that owns a bond. Many pension funds and retirees have seen a decade of lower returns on their bonds because of the low rates. Higher rates will help bring these returns back to normal levels.
Another interesting factor to consider is that many investors have been chasing higher yielding investments in the last few years due to lower rates on bonds. This "chasing" includes buying high yield bonds that often have much higher risk credit profiles. It also includes buying preferred stocks which also have historically higher risk profiles. Man folks also may have found themselves buying private REITs which have a much higher risk profile than a diversified bond portfolio. As rates rise, all of these investments begin to become incrementally less attractive and justifying the additional risk taken becomes tougher.
With so many different factors to consider as rates rise, it is tremendously important for all investors to review their portfolios. Almost every piece of your portfolio can be affected by changing interest rates. Talk to your investment professionals and financial consultants soon to make sure you are properly structured to take advantage of and also protect yourself from these potentially major economic shifts.
Various Interest Rates (October 5th, 2018)
The chart above illustrates various interest rates as of Friday October 5th, 2018. Notice the 10 yr Treasury is now paying around 3.231% return. 1 year Treasuries are paying 2.753% These are significant increases over even 1 year ago when the 10 year Treasury was paying 2.3% as seen below.
10 Year Treasury Oct 2017-Oct 2018
