The Long-Awaited Upward Hike
The Federal Reserve’s rate-setting Open Market Committee raised its targets for short-term interest rates this month as many market participants had expected. Fed Chair Janet Yellen used a press conference Wednesday afternoon to announce an increase of 25 basis points (0.25%) in both the discount rate and Fed Funds target rate.
The Fed is now officially targeting a 0.50% rate for Fed Funds, the overnight deposits that banks place with other banks. Banks often use Fed Funds as a baseline when setting the interest rate consumers and businesses pay to borrow money. The Fed’s action points toward higher borrowing costs all through the economy.
Major stock market indexes took the news in stride, holding onto strong gains of the past month while posting only a slight decline from record high levels set days earlier.
Bond markets had largely priced-in the change prior to the announcement. For example, the yield on one-month Treasury Bills, which closely tracks the Fed Funds rate, had already increased to near 0.50% by Tuesday from 0.25% in early November.
The rise in yields has been painful for longer-term bondholders. The 10-year Treasury Note yield rose to near 2.5% from 1.8%. This change in yield drove the price level for the 10-year Notes downward by more than 5%, wiping out several years’ worth of interest income in just a few weeks.
When long-term interest rates rise faster than short-term rates, as happened recently, the so-called yield curve is said to have steepened. A steeper yield curve can be interpreted as indicating investor expectations for further increases in interest rates. It can also be interpreted as an expectation for faster economic growth. Both of these interpretations bear watching as the new Trump administration takes office next month.
Investors have been watching for the Fed to raise interest rates ever since the last rate hike took place in December, 2015. Every Fed announcement since that time has basically said, “Not yet.” to the question of when the next increase would occur. There was never any serious suggestion from the Fed that rates might be reduced rather than increased.
The move upward confirms the Fed’s long-stated view that the U.S. economy is getting stronger based on reduced unemployment, rising consumer prices, and a firming-up in wage levels. It also keeps the Fed on a long-term path toward further rate hikes that the Fed has been telling Investors to expect. Investors may want to keep in mind that stock and bond market returns have averaged lower during periods when the Fed was raising interest rates in the past, compared to periods when rates were declining rather than rising.
Investors anticipating increases in interest rates should consider the potential impact of higher rates on different asset classes. High-dividend-yield stocks may be more likely to decline in price when interest rates increase rather than decrease. These stocks are often used as bond-substitutes by investors primarily focused on current income, and may tend to move up or down more closely in line with long-term bond prices. Shorter-term fixed-income securities may be less affected and afford an earlier opportunity to reinvest at higher rates compared to holding longer-term instruments. Stock market investors seeking growth may consider a preference for companies whose borrowing costs are well controlled and may be less likely to change quickly.
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