In a variation of an old advertising slogan, when the Federal Reserve talks, investors listen. The Fed has been talking about raising interest rates for several months and finally did what they were promising in the week ending December 18.
The only uncertainty was when rather than if the Fed would act. In recent weeks, central banks in other countries had kept interest rates unchanged and actually reduced rates to negative levels (less than zero percent) in some instances. But the head of the Federal Reserve, Janet Yellen, has continued to express concerns about inflationary pressures taking off with interest rates that are too low. So in this environment, the Federal Reserve did finally raise the “Federal Funds Target Rate” — by only 0.25 percent — to its new level of 0.5 percent.
Is this good or bad for financial markets? The initial response was positive — up 1.5 percent — but the next two trading days saw a total decline of 3.3 percent. Time will tell as Federal Reserve decisions are more commonly judged in the long-term such as quarters and years rather than short-term cycles such as a week or month. In this article, Research Optimus provides some observations about what interest rate changes can mean for businesses and individuals.
The Impact on Other Interest Rates
The rate adjusted by the Federal Reserve is the Federal Funds Rate — this is the cost of banks borrowing from the Fed. This is a “committee decision” rather than a unilateral decision by the Fed’s chief. The Federal Open Market Committee sets the Federal Funds Target Rate on a periodic basis.
By any standard, this rate is still extremely low. In comparison to the now-prevailing rate of 0.5 percent, in 2007, it stood above 4 percent. Nevertheless, consumers and businesses that have become comfortable with low rates for mortgages, credit cards and car loans will now see borrowing rates go up. Whether banks and other lenders restrict increases to 0.25 percent remains to be seen.
Additional impacts will also be witnessed in inflation and the value of the dollar. As noted above, however, some of the resulting impacts will be seen several months from now rather than immediately.
Think Long Term
Historically speaking, Federal Reserve tightening should have very little impact on stock and bond markets. Investors and businesses should pay more attention to the long-term trends. On that score, the Fed has already provided strong hints that additional interest rate increases are on the horizon during 2016 and beyond.
When borrowing costs increase, there are predictable consequences for businesses — less borrowing, less investment, slower growth, reduced liquidity, decreased earnings and lower cash flows. Since stock prices typically represent a discounted cash flow divided by outstanding shares, this can result in lower valuations for companies.
At the same time, bonds issued at higher interest rates can make bonds more attractive than stocks. Changing interest rates are often a suitable reason to adjust asset allocations assigned to an investment portfolio. However, it is worth remembering that financial markets react to many external factors in addition to interest rates. The past five years saw little (if any) interest rate adjustments and yet stock markets reacted favorably throughout this period. It is important for investors and businesses to pay attention to a lengthy list of external factors and not make financial decisions based solely on interest rates.
Investors should not be surprised by more volatility during a period of rate hikes. Short-term Treasury notes are likely to be more affected than long-term Treasury obligations. During previous rate hikes, stock markets frequently performed quite well because investors were more impressed by the Fed’s long-term confidence in the economy rather than short-term rate increases.
Monetary Policies Differ Throughout the World
The strength of the U.S. dollar should be on the “radar” for any American business. This can often be hard to track because not all central banks are pursuing the same monetary policy as the U.S. Federal Reserve. While many other central banks are attempting to increase liquidity, the Fed is striving to decrease liquidity. Quantitative easing is still being pursued aggressively by both the Japanese Central Bank and the European Central Bank.
In straightforward terms, any firm that does business internationally must pay particular attention to how their currency is behaving relative to currencies in countries where they are manufacturing, buying or selling. For example, 30 percent of S&P 500 revenues are generated overseas. Three industries that have especially high exposure to foreign currency volatility — materials, technology and energy — currently generate 40 percent of revenues from foreign sources. One of the best ways for businesses to keep track of what is going on in foreign investment and currency markets is to work with an international partner such as Research Optimus.
The Interest-Rate Conclusion: Businesses Need to Stay Up-to-Date
If there is one lasting “lesson” to learn from recent interest rate changes by the Federal Reserve, it is this — however they choose to do it, businesses must do their best to keep up with what all central banks are doing. Business owners, managers and executives need to pay attention to much more than just what the Federal Reserve is doing (or is about to do).
One of the most practical and cost-effective strategies for staying abreast of monetary policy throughout the world is to let an expert like Research Optimus do all of the “heavy lifting” in this specialized area that nevertheless can have a huge impact on the future financial health of your company.
– Research Optimus