How can the Fed’s actions affect you?
November 27, 2015
When will the Federal Reserve raise interest rates? This question has been on the minds of economists and financial market prognosticators for quite some time now. But what does it mean to you, as an individual investor?
First of all, it's important to understand just what is meant by "raising rates." The Federal Reserve, or the "Fed," directly controls short-term interest rates, although, through various measures, it can also affect long-term rates. Typically, the Fed will lower short-term rates to stimulate the economy. Conversely, the Fed will raise rates to slow down the economy if it seems to be "overheating" and threatening to push inflation to excessive levels.
Since the end of 2008, when the financial crisis hit, the Fed has kept short-term rates close to zero. But now, following several years of reasonably strong economic growth, the Fed appears poised to raise rates. No one can really predict the exact timing of the rate hike, but statements from the Fed indicate that it seems to be a matter of "when," not "if."
Fed chairperson Janet Yellen has indicated that when the increase comes, it may be relatively small, and that further increases will be spaced out enough to avoid potential "shocks" to the economy. Still, as an investor, you need to be aware of the potential impact of any interest rate increase. So, consider the following:
Review your bond holdings. As short-term rates rise, shorter-term bonds, and even some "cash" instruments, may eventually become more attractive than longer-term bonds, which tend to be more volatile. A sell-off of longer-term bonds can push their prices downward, so make sure these bonds don't take up too large a percentage of your fixed-income portfolio.
Build a bond ladder. A bond ladder may prove beneficial to you in all interest-rate environments. To construct this ladder, you need to own bonds and other fixed-rate vehicles, such as certificates of deposit (CDs) of varying maturities. Thus, when market interest rates are low, you'll still have your longer-term bonds, which typically pay higher rates than short-term bonds, working for you. And when interest rates rise, as may be the case soon, you can reinvest your maturing, short-term bonds and CDs at the higher rates. Be sure to evaluate whether the bonds or CDs held in the ladder are consistent with your investment objectives, risk tolerance and financial circumstances.
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Be prepared for volatility. Certain segments of the financial markets don't like interest rate increases – after all, higher rates mean higher borrowing costs, which make it harder for businesses to expand their operations. Therefore, depending on the composition of your portfolio, be prepared for some volatility when rates start moving up. However, since the Fed has already indicated it is likely to raise rates fairly soon, such a hike may already be largely "priced in" to the market, so any turbulence may be somewhat muted.
By taking these steps, you can help contain the effects of rising interest rates on your own investment outlook. Ultimately, as an investor, you need to concentrate on those things you can control, no matter what the Federal Reserve decides to do. And that means you need to build a diversified portfolio that reflects your goals, risk tolerance and time horizon. Maintaining this type of focus can help you – no matter where interest rates are headed.
This article was written by Edward Jones for use by your local Edward Jones Financial Adviser. Douglas J. Drost CFP Financial Adviser for Edward Jones, 2262 Reno Highway.