Federal Reserve Raises Interest Rates
For the first time in nearly a decade, the Federal Reserve (Fed) raised short-term interest rates. The widely expected 0.25% increase ended its zero rate policy. Short-term interest rates had been near zero for seven years. As a result, the Fed’s much-anticipated move has a higher profile than many past interest rate changes. Stocks rose in response, but bond prices fell, since bond prices typically move in the opposite direction from interest rates.
What’s the Likely Impact?
We think investors should view the Fed’s move as a positive sign. The Fed is finally comfortable with both domestic and international conditions, believing continued economic growth can withstand slightly higher interest rates. While markets may react sharply short-term, investors should expect:
Higher volatility in both stock and bond prices – Bigger stock and bond price movements (both down and up) are likely as the Fed provides less support for the markets. However, the overall outlook remains positive.
Interest rates still quite low – The Fed emphasized that it plans to raise short-term rates gradually and to keep responding to economic data. If inflation remains low, we expect interest rates to rise only modestly, staying well below historical averages.
Limited impact on housing and car sales – Although higher mortgage rates and more expensive loans could deter some buyers, rates are still attractive. Consumers have improved their finances over the past seven years by paying down debts, giving them the capacity to continue to make big-ticket purchases.
The Fed’s move may also result in further declines in high-yield bond prices, which dropped much more than the prices of investment-grade bonds over the past week. Those declines were tied to falling energy prices, since energy companies make up almost 20% of all high-yield bonds (versus 6% of the S&P 500). Distress about low energy prices doesn’t suggest a wider economic slowdown, so we don’t think the high-yield (or “junk”) bond market declines represent a warning for either stocks or the economy. But high-yield bonds tend to have high risks. And while we think higher rates adequately compensate for those risks, we recommend keeping high-yield bond investments to less than 10% of your portfolio.
Positive Outlook Includes Modestly Rising Rates
The Fed’s decision to raise short-term interest rates doesn’t signal the end of the bull market – historically, stocks and bonds have generally gained in the year following the Fed’s first rate hike.* We think continued modest economic growth and improving earnings growth can support rising stock prices over time. But be prepared for bumpier markets ahead, as conflicting trends collide. Owning bonds can help stabilize portfolios because bond prices tend to rise when stocks drop. Make sure your portfolio remains well-diversified with quality investments designed to help you stay on track toward your long-term goals.
Kate Warne, CFA, Ph.D.Investment Strategist* Source: Morningstar Direct.
Past performance is no guarantee of future results.