Here we go again: The Federal Reserve (Fed) just raised the federal funds rate target for the fourth time this year—and the ninth time in the last three years. The move was expected by most economists, although recent market volatility and increasing calls for the Fed to pause rate hikes resulted in a 68% implied probability of a hike the day before the announcement—the lowest level of this cycle. Since the Fed began its rate hiking cycle in December 2015, the day-before probabilities had ranged from 83% to 100%.
With the domestic economy showing limited strains at this point and a very tight labor market, a rate hike was largely priced in to expectations. Now that it has happened, how might it affect your investments? Here are five things to keep in mind.
1. Short-term fixed income investments are strongly influenced by the federal funds rate. The federal funds rate is an overnight bank-to-bank lending rate that the Fed can use to implement monetary policy. Put simply, when the Fed wants to tap the brakes on economic growth, it can raise the federal funds rate, making it more expensive for banks to borrow money from each other. Banks tend to scale back lending in turn, slowing the economy. (Conversely, the Fed can lower the rate when it wants to boost growth, allowing more money to circulate in the economy).
Because it’s a short-term rate, any changes tend to have the strongest impact on short-term instruments, such as deposit accounts, money market funds, Treasury bills, short-term bonds and short-term bond funds. When the federal funds rate is rising, it generally means that bank savings accounts and money market funds will pay a higher yield over time. As new Treasury bills and short-term bonds are issued, they should pay higher yields, too.
2. Intermediate- and long-term bonds may be less affected. That’s not to say intermediate-term bonds (generally, those maturing in five to seven years) or long-term bonds (maturing in 15 years or more) won’t feel it. But rates typically don’t rise in lockstep all along the yield curve.
“One thing to keep in mind that when the Fed raises short-term interest rates, it doesn’t mean all interest rates go up,” says Kathy Jones, senior vice president and chief fixed income strategist at the Schwab Center for Financial Research. “Long-term rates tend to be affected by other factors, as well—like the prospects for growth, inflation expectations, and generally the supply and demand for bonds that have attractive yields on a global basis. Not all rates are going to respond to a fed funds hike in the same way.”
3. The effect on savings accounts, CDs, mortgages, floating-rate notes and other products will vary. For example, rates on short-term certificates of deposit (CDs) probably will rise along with the federal funds rate, but not all CD rates will rise by the same amount. Longer-maturity CD rates may behave like intermediate- or long-term bond yields.
Adjustable-rate mortgages are usually tied to short-term rates, and if so, they can be expected to rise. However, fixed-rate mortgages generally track 10-year Treasury bond yields, and won’t necessarily move higher just because short-term rates do.
Meanwhile, although income from floating-rate notes should rise over time, it doesn’t always happen right away. Additionally, many floating-rate investments, like bank loans, have “caps” or “floors” that limit how much their coupon payments can change.
4. Expect continued volatility in the stock market. The Fed has been raising rates for three years, but only in the past year have overall financial conditions tightened as well. Tighter financial conditions tend to bring higher market volatility and lower valuations. In addition, the Fed’s moves on short-term rates aren’t the only factor driving stocks. Stock market performance is affected by the draining of the Fed’s balance sheet, the way longer-term interest rates move and the shape of the yield curve.
As things stand now, the yield curve is flattening as long-term interest rates have been falling while short-term interest rates have been rising. Bear markets and recessions typically follow yield curve inversions, not just periods of flattening—but concerns about the recent inversion in the “belly” of the yield curve and slowing economic growth have weighed on stocks. An inversion would likely be seen as a more dire warning sign for the economy (and stock market).
Stocks have historically had their worst performance within the six months leading into recessions, which means market action could be an important indication of recession risk heading into 2019. In addition, recessions have historically come after the Fed has finished hiking rates, not during a rate-hiking cycle; if the Fed opts to pause rate hikes in 2019, it could add to concerns about a coming recession.
We are arguably late in the economic cycle, and are seeing tighter financial conditions overall. So even if the economy and/or inflation are not yet overheating, it does suggest that heightened volatility will continue.
5. Tighter monetary policy and financial conditions, as well as other late-cycle tendencies, underscore the importance of discipline, diversification and rebalancing. A well-diversified portfolio—and in particular, rebalancing—can help keep you from being overexposed to areas of the market that may not perform as well in the future as they have in the past, and also help ensure that you’re appropriately weighted to investments that may now outperform.
Over time, “winning” investments will gain in value and take up a larger portion of your portfolio, while other investments will shrink in comparison. That can leave your portfolio unbalanced, and potentially increase your risk when market conditions change. Rebalancing involves periodically buying and selling assets to bring your portfolio back to your current desired asset allocation.
“Investors can’t control interest rates, credit spreads, currency values or Fed policy,” Kathy says. “But they can control what they own and how they position their portfolios for a range of potential outcomes.”
What you can do next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe.
- Want to talk about your portfolio? Visit a branch or find a financial consultant, or speak to a Schwab Fixed Income Specialist at 877-566-7982.
- Read Schwab’s 2019 Market Outlook for commentary on what may lie ahead for U.S. stocks and the economy, global stocks, and fixed income markets.