Are Interest Rates Going Up Sooner Than Expected?Brenda Whitman
Are Interest Rates Going Up Sooner Than Expected?
The recent announcement from the Federal Reserve that it plans to shrink its balance sheet has got some investors nervous that interest rates may be about to significantly increase. This creates a substantial risk for those who are invested in rate-sensitive products, particularly ETFs and mutual funds that invest in companies that borrow extensively.
Fed Ending Bond-Buying Policies
One key problem is that before the financial crisis hit in 2008, the Fed had around $1 trillion on its balance sheet, but its average daily reserves in 2016 were $4.1 trillion. This was a result of Fed policy that involved buying trillions of dollars of bonds in attempts to keep the market stable and interest rates low. The majority of bonds have a finite shelf life; as they expired, the Fed replaced them.
A Fed halt to these policies means more bonds are available to the market. The lack of automatic buying by the Fed also reduces some money for financial institutions. This may force up rates for customers as banks mitigate losses and risks.
Rate Hike Impact on Business
The rate hike on March 15 of 0.25 percent and two planned rate hikes later on this year also will affect businesses. As they adjust to these new rates, companies will have to consider whether they can afford credit-based expansion. It may also force struggling businesses under.
Recent Fed policies have kept the value of the dollar relatively low, so with rising interest rates, the value of the dollar in the currency market should also rise. This means those with short positions on the dollar may wish to sell, and those with short positions on other currencies — particularly sterling — may consider whether to increase the position.
With the rise in interest rates also comes a potential rise in inflation. These two key factors have a major impact on certain businesses, although the actual effects take about 12 months to make themselves felt. Increases in inflation can create wage hikes, so businesses with a large number of employees tend to suffer most. This includes the majority of retail and manufacturing businesses. As a result, their stock prices go down as the projected rate of return on each employee decreases.
On the other hand, telecoms and utilities tend not to be affected by such interest rate increases, as their market caps are extremely high compared to the number of employees that they have. They also tend to pay significantly above the minimum wage, so they can absorb increases to a certain extent. However, they’re also less likely to engage in major infrastructure upgrades due to the increased cost of borrowing.
All of these effects ripple across the entire economy, eventually resulting in economic expansion slowing down. As interest rates and inflation rise, gold tends to maintain its actual value, making it an ideal investment when you are hedging against rapid inflationary increases. If the value of the dollar rises, you can expect gold prices to dip, but increased inflation will stabilize that dip. It’s a worthwhile hedge either way, as the price of gold does tend to recover quite rapidly.