In the intricate web of the global economy, few elements are as influential as the U.S. federal interest rate. This crucial tool, which the Fed uses at its own discretion, impacts everything from personal savings to global markets, and each time The Fed announces an upcoming rate change, investors and newsreaders get worked up, waiting for the news that will dictate their next financial move. But what are these interest rates exactly?
In the context of what the Fed uses, interest rates can be simply understood as the cost of borrowing money or, conversely, the reward for lending it. When interest rates rise, borrowing becomes more expensive, dampening business investment and consumer spending, often slowing economic growth.
Conversely, when rates are lowered, borrowing becomes cheaper, which can stimulate economic activity; hence, the lower and lower rates in the pandemic era when the government attempted to keep the economy afloat through cheap credit. However, these are not hard and fast rules, as a range of other factors can influence the effects.
Understanding the impact of interest rates is especially important for retirees and those nearing retirement. Interest rates heavily influence the returns on savings and investment accounts, such as the income from bonds and dividend-paying stocks and the cost of borrowing.
When Interest Rates Go Up
When interest rates rise, the cost of borrowing increases. This disincentivizes businesses from taking on loans for expansion, potentially slowing economic growth. For retirees, higher interest rates can increase the income from newly-purchased interest-bearing assets like bonds, certificates of deposit (CDs), and savings accounts.
Of significant importance to a retiree, who likely has a considerable amount of bonds in their portfolio, is that the market value of these existing bonds could decrease as new bonds offering higher interest rates become available. So, if you need some money and would like to sell those bonds, you may want to think twice, as you may end up with a capital loss. Also, if you’re still paying off debt, like a mortgage or a home equity line of credit, the cost of that debt could increase.
When Interest Rates Go Down
Conversely, when interest rates fall, borrowing costs decrease, which can stimulate economic growth. Companies may increase their borrowing in an attempt to expand, and consumers may also borrow more, in theory fueling economic activity. For those nearing retirement who are starting to purchase more and more bonds as part of a risk mitigation strategy, lower interest rates could reduce the income they receive from their new interest-bearing investments.
Additionally, while existing bonds might increase in value due to their higher yields relative to newly issued bonds, future income potential could decrease as they mature and need to be replaced with new bonds offering lower yields. Lower interest rates could also reduce the growth of savings in interest-bearing accounts like CDs or high-yield savings accounts.
Also, low-interest rates can affect inflation, which, in turn, will hurt your purchasing power. You may find yourself in a situation where you want to start purchasing more bonds instead of risky stocks, but those bonds don’t have a high coupon rate, and inflation starts to push down the real value of that already low bond yield.
So let’s look at some scenarios where you’re portfolio is either light on bonds or stocks according to interest rate moves.
Rates Go Up, Your Portfolio is Stock Heavy and Light on Bonds
Stocks: Volatile, might decrease in the short term due to increased borrowing costs for corporations.
Bonds: Market value may decrease, but interest rates on new bonds will increase.
Possible Advice: Consider adding more bonds to your portfolio for higher yields and more fixed income.
Rates Go Up, Your Portfolio is Stock Light and Heavy on Bonds
Stocks: Might decrease, but it’s a potential opportunity to buy at lower prices.
Bonds: Market value may decrease. However, the yield from newly issued bonds will be higher.
Possible Advice: Consider a bond ladder strategy to manage interest rate risk. Also, consider purchasing stocks at discounted prices if your risk tolerance allows.
Rates Go Down, Your Portfolio is Stock Heavy and Light on Bonds
Stocks: Likely to increase due to cheaper borrowing costs for corporations, but beware of potential market bubbles.
Bonds: Yields might be lower, but they provide a stable income stream which will help if a stock market bubble bursts.
Possible Advice: Maintain a diversified portfolio to balance the growth potential of stocks with the stability of bonds.
Rates Go Down, Your Portfolio is Light on Stocks and Heavy on Bonds
Stocks: Likely to increase due to cheaper borrowing costs, presenting an opportunity to diversify into equities.
Bonds: The real return may decrease due to potentially higher inflation, but nominal return remains the same.
Possible Advice: Consider diversifying into stocks or inflation-hedging assets like certain real estate types or REITs.
Exceptions, Of Course
It should go without saying that this is generic advice. Each scenario may affect different companies and industries differently, and things don’t always move in the direction we would expect them to.
For example, banks may make more money in a high-interest environment due to the widening spread between long-term and short-term interest rates. Large firms with enormous cash reserves are less likely to need to borrow during high rates, meaning their bottom line won’t be directly affected by increased borrowing prices.
Alternatively, utility companies may have a tough time in periods of low interest rates due to their position as bond proxies. Investors may ditch utilities’ predictable and stable returns in search of assets with growth potential.
Geopolitical tensions, natural disasters, and a multitude of other factors may play a more significant role in affecting your retirement plans and price directions as well.
In Conclusion
So, what can we conclude from this? Adapting to rising and lowering interest rates is a careful balancing act, like a game of tug and war on your financial plan. How can all the different pieces fit together with this huge variable shaking things up every few years?
You need to build up your nest egg. You need to outpace inflation and your debts, craft a careful withdrawal plan to not risk running out of money, plan for exorbitant medical costs, and stay in the lowest tax bracket possible throughout, all while having to be flexible enough to adequately react to changing interest rates? And hopefully, leave something behind for your loved ones with a comprehensive estate plan?
Weren’t these supposed to be your golden years?
Well, that’s why we’re here.
As dual fiduciary financial advisors and CPAs based in Florida, we are uniquely certified and experienced to guide you through these intricate economic dynamics. We can work together to evaluate your current portfolio, consider how changes in interest rates might impact your investments, and adjust your investment strategy as needed.
We want to help you achieve a future where you can enjoy your retirement years with financial security and peace of mind.
