The decision by Federal Reserve System to raise interest rates came as no surprise. Last week, the Federal Open Market Committee (FMOC) met and decided to increase its key Fed funds rate by 0.25 percent to a range from 0.50 to 0.75 percent.
This is only the second increase in eight years. The Fed funds rate is the interest rate that banks or similar institutions charge other banks for unsecured short-term loans (typically overnight) to help meet Federal Reserve requirements.
The move indicates that the Fed is confident in the health of the U.S. economy and believes the labor market and inflation are on the right track. Of course, because the market absolutely expected this rate hike the impact on your portfolio will likely be minimal. The market reacts to surprises and this was by no means a surprise. Rather, it was a step toward normalcy. After all, until all the quantitative easing in 2008, the Fed funds rate had never been below 1 percent!
Accordingly, we should also pay close attention to the Fed’s stated plans to raise rates three times next year to arrive at a “normal” 3 percent by the end of 2019. Interestingly, the FMOC’s “dot plot” only showed three hikes after the Fed’s September meeting. This trajectory for increases would be a little faster than some expected but, importantly, it is not set in stone. Remember that we expected multiple rate hikes this year and we did not see an increase until December.
But what does this move mean for your portfolio? First of all, the price of a bond typically decreases when interest rates increase. However, if you hold individual bonds to maturity, you typically will get all of your principal back. Furthermore, short-term bonds will fluctuate less in value than long-term bonds which means investors should only hold short- and intermediate-term bonds.
The impact of rising rates is less definitive for stocks. Some sectors actually perform better with rising interest rates. A higher Fed funds rate means you earn more interest in your saving accounts or money market accounts. For borrowers, higher rates can lead to higher borrowing costs. For example, if you have an adjustable rate mortgage tied to the prime rate, your monthly payments could increase with the increase.
The bottom line is that uncertainty in the market underscores the need for a diversified investment plan. In that way, you will be positioned to take advantage of emerging opportunities and to mitigate risk regardless of the direction interest rates take. And in addition to watching the Fed, there may be policy changes with the new Trump administration and even potential tax reform that could trigger moves in the market that make portfolio diversification all the more important.