Not a day goes by that there isn’t speculation in the financial newspapers about how the interest rate is going to evolve over the next few months and years. Most people don’t realize how important interest rates are to the economy -so much so that there is an entire federal government institution, the Federal Reserve (the Fed), dedicated to managing inflation, growth and the general health of the economy. At the head of this institution, is the Fed chief-Benjamin Bernanke, who is constantly sought by the President and Congress on these important economic and fiscal matters. One of the Fed’s goals is to manage interest rates, which are adjusted on a quarterly basis and impact many different parts of our lives from mortgage financing and investment strategy to private business spending.
Bernanke has said that he expects to keep interest rates at near zero levels for the time being. The consensus among experts is that it will remain at the current 0.25% till at least mid to late 2015. Bernanke himself has expressed that “The Fed will keep the federal funds rate near zero until the unemployment rate falls below 6.5 percent.” The federal funds rate is the rate charged when banks borrow from other banks and the reference rate used when speaking on all other loans and borrowing activity.
Impact on Homeowners
What does this mean for homeowners with mortgages or those looking to buy homes? Our current interest rate environment makes it a buyer’s market. At the height of the market in October 2007, right before the financial crisis hit, the 30-year fixed mortgage rate was 6.38%. The 30-year fixed rate in January 2013 was 3.41% leading to many homeowners pursuing refinancing.
Those who are unsure about the time to refinance should know that as the economy improves the rates will increase, and as such the benefits of refinancing will decrease. In September, the rates jumped when many believed the fed would start tapering their bond purchasing program, granted it didn’t happen, the rates reflect that it will happen sooner rather than later.
Impact on Stock and Bond Markets
Let us examine how interest rates affect the stock and bond markets where a majority of Americans invest their savings. 2013 has been a great year to be investing in stocks. Market participants have seen a year to date appreciation of 14.83%.
Traditional investment portfolios tend to invest the majority of their assets in equity and fixed income, leaving a small portion in other asset classes-cash, real estate, hedge funds, commodities etc. Whereas the equity portion of investors’ portfolios have done well, the fixed income has been lagging due to the low yields. Investment managers and wealth management professionals have had to deviate from their traditional weightings to take advantage of the equity performance as well as pursue non-traditional fixed income strategies such as riskier high yield bonds.
The future is a matter of concern as well-for two reasons. First, the stock market cannot continue such a stellar performance forever, so we might experience a bit of a pullback in equities.
Second, while the stock market may have gotten ahead of itself, other economic indicators such as new jobs (an average of 195,000 per month) and existing home sales have shown a sluggish U.S. economic recovery.
If investors believe that the economy will do better, they expect Ben Bernanke to raise interest rates which will adversely affect the fixed income portions of investment portfolios because of the inherent inverse relationship of bond values and interest rates. For this reason, the fed has been open with its monetary policy-to allow investment professionals to adjust their portfolios accordingly. This situation affects everyone not just Wall Street.
Although investors not already in bonds will welcome the higher yields from increased interest rates, those with bond exposures will have to reduce it or hedge it with derivatives.
Impact on Businesses
This low interest rate environment also affects businesses, large and small. The main reason for this specific monetary policy was to spur business investment which would lead to economic growth. The thought process was that with lower rates, business expenditures would be lower. This interest rate environment works differently for different sized companies. Since large corporations have a reasonable balance sheet, banks are open to advancing them money even though the returns are not great but they are positive and secure. As a result, big companies are able to make investments at a much lower cost.
Their effect on the economy however is small as they are producing an ever smaller number of jobs in the economy.
On the flip side, small companies are creating the majority of new jobs but because they haven’t performed well recently, banks are reluctant to lending them money because the interest received is low, and small businesses run the risk of defaulting. This doesn’t appeal to the increasingly risk-averse banks of today. Instead of the increase in business investment the Fed had hoped would happen, banks have learnt their lesson from giving out loans to unqualified recipients and instead are holding onto it to increase their stability by keeping extra reserves.
The post financial crisis environment is an interesting one. In the past, whether it was in 1993 or 2001, whenever we came out of a financial down cycle our economy would demonstrate strength by growing at above average growth rates. This is the first time that our economy has not demonstrated sustained recovery, instead growing at 1.5-2%, prompting an unorthodox monetary policy from the Federal Reserve. Interest rates are not a purely theoretical concept-it has far reach effects in many areas of our lives.
Understanding it will allow one to benefit from the current environment and its impending increase in the coming years.
Rahul Varshneya graduated from the Leavey School of Business at Santa Clara University with a degree in finance and is working in the technology industry as a financial analyst. He is currently enrolled in the chartered financial analyst (CFA) program.