What Does The Rate Increase Mean?

Since 2006, Federal Reserve interest rates had been floating around zero, but yesterday it was announced that there would be an increase of 25 basis points. Janet Yellen, Chair of the Federal Reserve, went on to promise a gradual rise in interest rates with a target of 1.5% by the middle of 2017.

It was an increase which has been expected for some time, and had become more or less inevitable. If rates had stayed at zero heading into the New Year, in all likelihood the market would have suffered from such a negative outlook.

Janet Yellen has been Chair of the Federal Reserve since 2014.

The S&P 500 saw a modest bump yesterday and ended the day 1.45 percent higher. Many of America’s largest banks (such as Wells Fargo, JPMorgan Chase, US Bancorp and Citibank) then followed suit shortly after Yellen’s speech in announcing increases in their prime rates, which govern consumer loans such as mortgages.

This initial increase though, as Yellen herself alluded to, will have a marginal, near inconsequential, effect on individuals for now. While some borrowing rates will see a slight increase, it won’t be until several years down the line after a series of interest rate hikes that consumers will begin to feel the cumulative effect.

What should we be aware of though when it comes to our portfolios? You can expect to see the prices of existing bonds to fall as newly issued bonds have higher yields. Research by the American College of Financial Services has also shown that when interest rates rise commodities perform dramatically better than they do in periods of falling rates. U.S. equities have typically shown growth in the twelfth months following an initial rate hike, and coupled with falling oil prices, we can expect them to continue their positive trajectory for the time-being.

In terms of the average American consumer, those with adjustable-rate mortgages can expect their payments to see a small bump, albeit nothing drastic right now. Adjustable-rate mortgages can only be adjusted once per year as well, although several increase rates by the Federal Reserve in the space of a year could see you facing a significant increase when your mortgage rate does increase. People in the market for a new home would be prudent to make their purchase now if interested in a fixed-rate mortgage before rates climb further.

Expect the number of new mortgages to increase along with interest rates.

Expect an increase in credit card rates as well. However, NerdWallet has estimated that the average indebted American household can expect to only have to spend an additional $125 in credit card interest over the next five years.

While primarily a symbolic (and optimistic) move, the Fed no doubt hopes that the economy will see fast improvement off the back of the hike. It is worth bearing in mind that inflation is still running below 2%, full-time unemployment is hovering around ten percent, and the labor participation rate still sits at 62%, a near-40-year low.

There is considerable hope that the labor market continues to recover.

Furthermore, rising interest rates, even if gradually implemented as was stressed, means a large increase in servicing the national debt. The CBO (Congressional Budget Office) has estimated that by 2024, $800 billion of our tax dollars every year will be going to service our public debt. Currently, it is around $200 billion a year, a sum that’s low due to the era of low interest rates. By 2024, net interest payments would equate to 3.0 percent of GDP it is estimated, the highest ratio since 1996.

The federal budget deficit is also increasing after several years in decline, and will reach a trillion dollars a year again by 2020. By 2025, the national debt is projected to be more than $27 trillion. This coincides with the announcement yesterday of a trillion dollar spending bill being agreed upon by both sides of the House.

Whoever is elected to be the next President of the United Sates in 2016, they face the serious issue of balancing the government’s books and bringing spending under control. For now though, it is of paramount importance that the domestic economy prove its strength amid a myriad of potential global troubles: China’s economic problems, Europe’s debt, low inflation and the rise of terrorism.

For now though, there is no need to make any drastic changes to a well-balanced and diversified portfolio. It will be a little while yet before the repercussions of raising rates begin to take serious effect upon the markets and your investments.

For now, we wait to see how America’s economy responds.