Understanding the Rate Hike

For months, there’s been talk of the Federal Reserve raising interest rates, and some market commentators have been stirring up fears about how that may impact investors.

At Acorn Wealth Advisors, we believe long-term investors have little to fear from rising rates. Let’s take a step back and look at why, starting with why the Federal Reserve wants to raise rates.

A fundamental part of the Fed’s job is to help the economy to grow and create jobs. (The other principal duty of the Fed is keeping inflation under control.)

From the Fed’s perspective, interest rates can function as a gas pedal or a brake: Lowering rates can spur economic expansion, while raising them is like tapping the brakes.

In response to the 2008 market crash and the recession that followed, the Fed slashed rates to zero, where they’ve remained ever since. The economy is now well into its recovery. The recovery has been slow and gradual to be sure. But unemployment has dropped to near 5%, and other fundamentals look relatively strong.

Why not continue with rock-bottom interest rates? For one reason, cheap money tends to lead to bubbles after a certain point, and bubbles are made to pop. The results can be disastrous, as we saw with the 2008 real estate crash.

The Fed’s raising interest rates also gives it some ammunition to fight any future recession. Only by raising rates in good times will the Fed have room to lower them when it really needs to.

So there are good reasons for the Fed to “normalize” rates. Fed chair Janet Yellen and her colleagues are expected to start raising rates sometime between September and early 2016, although they could delay action if new threats to economic growth appear.

Rising rates may concern investors for a couple of reasons. They drive down the value of fixed-rate bonds, which would affect investors planning to sell their bonds before maturity. However, shorter-term bonds are less vulnerable to interest-rate risk.

Second, low rates have helped to spur the bull market forward. As that changes, we may see short-term volatility. Indeed, the expectation of rising rates has been weighing on the stock market for much of this year. This is more of a concern for active, short-term traders than for patient, long-term investors.

Long-term investors should bear the following in mind:

  • The Federal Reserve raises and lowers interest rates continually, as conditions warrant. The Fed raising rates now would signal confidence in the economy. By the way, most economists expect U.S. gross domestic product to grow 2% to 2.5% a year for the foreseeable future.
  • Yellen has signaled that the Fed will raise rates gradually. If the Fed raised rates by .25% every quarter for the next four years, rates would still be below their 2006 level. And in 2006, the stock market climbed in excess of 13%.
  • History is reassuring. Since 1945, the S&P 500 index has returned an average of 2.4% in the six months after the Fed starts raising rates.

In understanding the market, context is everything. When you hear commentators bemoaning the Fed’s plan to raise rates, understand that their goals may be short-term, and their interests different from yours.

At Acorn Wealth Advisors, our investment portfolios are built to navigate through changing interest-rate, economic and market conditions. This approach provides the surest and safest way to help you meet your long-term goals. We invite you to get in touch if you’d like to discuss your investment portfolio.

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