Today the Federal Reserve raised the target rate for the Federal Funds rate by .25%. This changes the target range from 0% -.25% to .25% – .50%. Simultaneously, the Federal Reserve announced that future rate changes will be gradual. Is a .25% change in rates significant? Is it good or bad to have interest rates increase? What do the Federal Reserve’s actions mean for the economy and investors? Are my investments allocated for a rising interest rate environment?
The actual increase of the Federal Funds rate by.25% is not material. Corresponding changes in savings rates, money market rates, and borrowing rates will be mostly unnoticeable (for now). For example; the Fidelity Money Market fund has seen its seven day yield increase from .01% to .02%. However, the change to a tightening policy is highly significant. The action today ends an eight-year period (to the day – 12/16/2008 to 12/16/2015) of 0% short-term interest rates. There are 30 year-old investors who have never earned interest on savings balances during their professional lives. The change in policy will create volatility in the stock market and uneasiness with investors. The velocity and size of future rate changes must be analyzed carefully. Undoubtedly, new opportunities for growth and income investments will unfold.
It is good for the economy to be in a position to support higher interest rates. The move today by the Federal Reserve validates a healthy economy. An increase in short-term rates reflects an economy that boasts a 5% unemployment rate, has created 2.2 million jobs in 2015 (U.S. Bureau of Labor Statistics), and growing corporate earnings. Higher short-term rates will help conservative and income investors generate positive yields from savings balances. However, as rates increase the value of residential real estate will fall as fewer borrowers will qualify for higher home prices. There is also a heightened level of systematic risk to the economy if the tightening cycle is mismanaged by the Fed. If the rate increases are adjusted too much, too soon the U.S. economy will slow. Although this is unlikely, it remains a risk that must be watched.
D’Arcy Capital has allocated portfolios specifically for a rising rate environment. These allocations include bond investments that contain floating rate notes, short-maturity bonds, and inflation protected Treasury bonds. The stock investments at D’Arcy Capital are also biased towards higher interest rates. These investments include an overweighting to U.S. financial companies and underweighting to utility companies. During (and right after) an increasing interest rate cycle financial institutions such as banks have the ability to increase profits. Their interest rate spread (the difference between the interest they pay on savings accounts and the interest they receive from the loans they make) gets wider as banks are able to rapidly adjust the interest rate they charge borrowers but slow to change the yield they pay for savings and checking accounts. By contrast utilities struggle during higher interest rate cycles because the rates charged by utility companies can be hard to change. These rates often require the approval of an oversight body. Additionally, the high dividends paid by utility companies become less attractive as competitive savings rates start to increase.
Although uncertainty will continue to exist while the Fed tightens the money supply, the action today is a great indicator of a high potential future for investors. The Federal Reserve has probably waited too long to start raising rates. However, with a well-managed allocation investors can significantly benefit from this dramatic change in Federal Reserve policy.