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If you keep up with general world news or news surrounding the markets you have probably heard a lot of chatter about interest rates. There is great speculation on whether or not there will be a rate hike in the coming months. Many people out there might be thinking, what would an interest rate hike do? What interest rates are they talking about? How would a rate hike affect my portfolio? In this article, I’m going to be covering the basics of interest rates and give you a firm understanding of how they could impact your investments.

 

Basic Economics

 

To understand interest rates, we first have to take a step back and look at how the economy functions. The economy runs off of spending and transactions. When interest rates are low it is more attractive to borrow money in the form of credit. When there are more people borrowing money with credit, there is more transactions and spending that occurs. One person’s spending is another person’s income. The more income someone has the more buying power they have to purchase other goods and services. This begins to compound and the economy flourishes because of it.

 

Federal Funds Rate

 

The federal funds rate is the interest rate everyone is referring to when they are talking about rising rates. There is a central bank in the United States and the Federal Reserve sets a minimum reserve requirement that banks must hold to protect against bank failure. For example, let’s say Bank of America currently has 100 million in funds at its bank and it pays out 95 million to other customers. This only leaves 5 million left in reserves. If there is a surplus of customers that come in at once wanting deposits, then this can cause the bank to run out of money (bank failure). To protect against this, the bank set the minimum reserve requirement which is usually 10% of deposits. So if a bank had 100 million in deposits then its minimum reserve requirement would be 10 million.

The federal funds rate is the interest rate banks charge each other for overnight loans. If it is the end of the day and the bank does not have enough money in reserves to meet its reserve requirement, then it will borrow from other banks and will be charged interest at the federal funds rate.

You might be wondering, if this interest rate is what banks charge each other, then how does it affect me? The Federal funds rate can be viewed as a base rate that determines the level of all other interest rates in the US economy. When interest rates are low it induces more inter-bank borrowing in order to re-lend to consumers and businesses. Remember when interest rates are low it is more attractive for people to borrow money. Interest rates have been at 0.15% for a while now so you could see how it can be attractive to borrow more.

Why the Fed Raises and Lowers Rates

 

I’m going to break down the cycle of events that occurs that leads the fed to raising rates as simply as possible.

  1. When Interest rates are low it is more attractive to borrow
  2. Increased Borrowing (credit) leads to more spending
  3. More spending leads to increases in income
  4. Increases in income leads to more money spent
  5. More money spent leads to growing economy and increased demand for goods/services
  6. Increases in demand causes increases in prices (aka INFLATION: more dollars can purchase LESS goods/services)
  7. To make sure inflation does not get out of control the Fed will increase interest rates
  8. Rises in interest rates makes it less attractive to borrow (Think about it like a rise in credit card rates; you have to pay more on interest payments and have less disposable income)
  9. Since there is less money flowing through the economy prices will retract

This cycle continues over and over depending on how the economy is functioning. The main reason the fed raises and lowers interest rates is to keep inflation under control. The fed would like to see inflation rise at a decent pace, roughly 1-3%. When it starts climbing at a rapid rate, such as 5-10%, then things can get out of control. This rapid rise in inflation will lead to higher rents, higher tuition, higher food, and higher transportation. Remember raising rates will reduce spending/borrowing and lowering rates will increase spending/borrowing. This is why the fed began to lower interest rates in 2007 when our economy was starting to collapse. They needed to stimulate the economy and get more money flowing again.

fed-funds-rate

 

How Rates affect the Stock Market

 

There is a ripple effect that occurs when interest rates are changed that is reflected in the stock market. Recall that a company’s stock is priced for FUTURE expectations of performance. This includes FUTURE cash flows. If interest rates rise there is LESS money flowing in the economy. With less money it is less attractive to borrow and people have less disposable income to spend on certain companies products and even the stock itself. Think about it, what money do you use to invest? It’s only savings and reserves after you pay all of your bills. If you have less disposable income this means less money spent on companies causing their future cash flows to decrease. The immediate effect of a rise in interest rates is going to be a pull back in the market because stocks are priced for the future. Lately, there has been more dramatic pullbacks because we have not had a rate increase in over a year. There is a good chance that we will see a rate hike in December because there has been lots of positive economic data recently. Recall that the fed wants to be one step ahead of inflation so it does not get out of control. The initial effect will be a drop in the value of your portfolio but it should NOT lead to a long-term bear market or anything of that nature.

 

Homework: Go back through the steps of why the fed raises/lowers rates and make sure you fully grasp the concept. It is essential to understand and is the basis of how the economy functions. Think of some ways you could make money off of a temporary correction of the stock market if we do see a rise in rates.