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Implications of the Federal Reserve's

Impending Rate Hike


By Adam Hayes, CFA
The Federal Reserve begins its two-day meeting on Wednesday, September 16, and everyone
is watching to see if the central bank will raise the United States target interest rate for the
first time since the Great Recession. The target rate has been set at historic lows between
0.00% and 0.25% since 2009 in order to stimulate economic growth. When the Fed raises its
target interest rate, other interest rates throughout the economy will feel a ripple effect. Hence
why many fear a rate hike while others welcome it. (For more, see Timing the Fed Interest
Rate Hike.)
Here are some implications of an interest rate rise.

Savers May Benefit


Individuals who deposit money at banks will see the interest rates credited to their savings
accounts rise. Certificates of Deposit (CDs), money market accounts and other savings
instruments will also see a benefit. Currently, the average interest rate credited on U.S.
savings accounts is a paltry 0.09% while a 1-year CD averages a yield of 0.28%.
Of course this benefit s predicated on the assumption that an increase in interest rates wont
be accompanied by an increase in the inflation rate, which can erode the purchasing power of
cash savings. One of the factors motivating an interest rate increase is that the economy has
recovered enough for positive gains in GDP and employment both of which can lead to
increased inflation. (For more, see The Importance of Inflation and GDP.)

Consumers May Buy Less


Many consumers make purchases on credit, using credit cards, lines of credit or tapping into
home equity. The interest rates due on credit cards and consumer loans will tick up. As
interest rates rise, the interest payments incurred monthly to service those debts also increase;
thus, consumers are discouraged from taking on large amounts of debt, consequently
lowering consumption. Consumers may also become more motivated to save more money
given the new, higher rates they can earn at banks, which also reduces the amount of money
left to spend. (For more, see How Do Interest Rates Coordinate Savings And Investment In
The Economy?)

Bond Prices May Fall


Bonds, whether issued by the government or corporations, are debt instruments with prices
that are sensitive to interest rates. The price of a bond varies inversely with changes in
interest rates: if interest rates go up, bond prices go down. Investors who are holding onto
bond portfolios, especially with fixed-rate bonds, can expect the values of those bonds to fall

with a rate hike. (For more, see Why Do Interest Rates Tend To Have An Inverse Relationship
With Bond Prices?)
However, long-term buy-and-hold bond purchasers who seek to earn cash flows from regular
coupon payments and pay little attention to bond values will be able to buy new bonds that
offer higher coupon rates.

Stock Prices May Fall


Stock prices are determined by future profits that corporations will generate. At very low
interest rates, companies are able to borrow larger sums of money to fund the undertaking of
projects that should yield some positive return. In a competitive market, the ability to borrow
money at very low rates allows corporations to invest in projects that have narrow profit
margins. Raising the cost of borrowing for a company, by even a little bit, can cause these
projects to suddenly become losers, reducing profitability and lowering stock prices. Market
fundamentals indicate that stocks are relatively expensive compared to historic levels based
on earnings multiples, and a higher interest rate environment may make them look even more
costly.
Furthermore, as mentioned earlier, consumers may also cut back on purchases, which will
negatively affect companies revenue numbers and cause further damage to their bottom
lines.
Low interest rates have also encouraged traders and speculators to bid up the price of stocks
as they are able to purchase shares on margin. If interest rates rise, the cost of leverage will
also rise, causing these stock owners to pare down their holdings by selling stocks in the
market.

Home Prices May Fall


Consumers may not only cut back on using credit cards, but also on buying homes and
property. Most homebuyers use mortgages to finance their homes, and if mortgage rates
increase, which will happen with a general rise in interest rates, the cost of owning a home
will also climb. The uptick in the cost of homeownership can reduce demand for property.
Housing prices have recovered quite a bit since the housing bubble burst, but mortgage rates
on both fixed and variable loans have fallen to historic lows over the past few years. This low
interest rate environment helped boost home prices as the favorable mortgage conditions
allowed more people to buy homes and enabled existing homeowners to refinance older,
higher loans and free up cash flow. (For more, see Real Estate Investing in a High-InterestRate Environment.)

Exports May Drop


An interest rate increase could make the U.S. dollar more attractive as an investment, causing
the value of the dollar to rise against foreign currencies. A more valuable currency is
damaging to exporters since it makes their goods relatively more expensive when translated
to other currencies. For example, if a U.S.-made car sells for $30,000 and the exchange rate

with the euro is currently $1.10 per euro, it will cost around 27,272 euros in the EU. If the
dollar strengthens and the exchange rate rises to $1.05 per euro, the same car will now cost a
European consumer 28,571 euros.

The Bottom Line


The Fed is expected to soon raise interest rates above its historic lows of around zero percent
for the first time in years. Ultimately, such an interest rate hike signals that the economy is
stable and growing, and that key indicators, such as unemployment and GDP growth, point to
economic expansion.
There will, however, be some negative implications. Stock prices, bond prices and home
prices may all fall as a result, since the persistent low interest rate environment that has
existed since 2008--2009 has become one of the drivers of price appreciation in these asset
markets. A sudden change to that status quo, even if seemingly marginal at 25 or 50 basis
points, it could effectively double the cost of short-term borrowing which could ripple
through the economy. (For more, see Is a Rate Hike Already Priced Into the Market?)

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