Interest rates could soon rise in the U.S. for the first time in almost a decade, and that’s shaking up financial markets.
If you own stocks of Coca-Cola or Procter & Gamble, you may already see the impact in your 401(k). And if you’re making plans to visit Europe, you’ve probably noticed the dollar has surged against the euro.
These shifts can all be traced back to the Federal Reserve and what it decides to do with rates.
Since December 2008, the central bank has held its benchmark rate close to zero to support the economy by encouraging borrowing and spending. It’s been even longer since the Fed actually raised the cost of borrowing. That was back in June 2006.
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In a statement released Wednesday, the Fed opened the door to a rate increase later this year by no longer saying it will be “patient” in starting to raise its benchmark rate. Areas of the economy appear to be stuttering, but the jobs market has strengthened, and some analysts think the Fed could lift rates as soon as June. Higher rates are meant to combat inflation, which is a risk if wages and prices start to edge higher along with the jobs market.
But investors aren’t waiting for the Fed to move. They’re already favoring stocks they think will do well under an improving economy – and the higher rates that come with it. They’re also steering away from investments they think will suffer.
Russ Koesterich, chief investment strategist at Blackrock, the money manager, says investors should expect “bigger drops and bigger swings” in the market as people scramble to adjust their portfolios after six years of near-zero rates. “This is going to be a change in the environment.”
Here’s how the prospect of higher rates is shaping stocks, bonds, borrowing and saving:
Losers. People holding utility stocks have suffered losses this year. Utilities as a group have slumped 7.1 percent in 2015, the biggest loss among the 10 industry sectors that make up the Standard & Poor’s 500 index.
These stocks typically pay dividends that are high relative to their companies’ share prices. They were in demand last year, when government bond yields fell, and investors wanted them for the level of income they were no longer able to get from bonds.
Now, as yields on those ultrasafe bonds have edged higher, these stocks are less attractive. The yield on the 10-year Treasury note, which had dropped as low has 1.64 percent in January, has climbed to 1.93 percent. Dividend-rich stocks, which carry more risk than Treasurys, look less attractive.
Other stocks that traditionally pay big dividends to investors, such as telecommunications companies, have also started to struggle. Telecoms have fallen 3 percent this month.
Possibly the biggest impact on stocks has been from the currency market, where the dollar has surged.
The dollar index, which measures the strength of the U.S. currency against a basket of others, is up 10 percent this year.
As the U.S. currency climbs, companies that rely on overseas sales for a large portion of their revenues have seen their stocks slide.
Investors who own Coca-Cola, which derives more than a third of its sales from outside the U.S., have seen the stock slump 3.7 percent this year. Procter & Gamble, owner of the Gillette and Crest brands, is down 7 percent. The S&P 500 index is up 2.4 percent over the same period.
Winners. Stores, restaurants and media companies should be among the better performers this year as the U.S. economy continues to strengthen and hiring picks up. Low gasoline prices will put more money in people’s pockets, also helping consumer-focused stocks.
Consumer discretionary stocks are the second-best performers of the sectors that make up the S&P 500. The industry group is up 4.5 percent since the start of 2015.
Americans’ willingness to spend “isn’t going to be much affected by the rise in interest rates; it will be more impacted by the fact that the economy is getting better,” says Karyn Cavanaugh, senior market strategist at Voya Investment Management. “It’s a better economy, it’s a better job market, and that’s why the Fed is raising rates.”
Losers. The biggest threat to investors from rising rates could come from the investment considered the safest, namely U.S. Treasurys, says Jim Paulsen, chief investment strategist & economist at Wells Capital Management.
Prices for Treasury notes have rallied since the start of 2014, sending their yields lower. The trend surprised many analysts who expected bond prices to fall as the Fed wound down a massive bond-buying program that was part of its effort to boost the U.S. economy. But as economies in other parts of the world struggled or slowed, investors bought more ultra-safe Treasurys, and drove prices higher.
Treasury prices are “very, very much out of line,” given the relative strength of the economy, says Paulsen. The unemployment rate has fallen to a seven-year low of 5.5 percent, and most economists expect the economy to grow around 3 percent this year. At 1.93 percent, the yield on the 10-year Treasury note is lower than 3 percent level from six years ago, during the recession.
“The message from the bond market, supposedly, is that the world today is worse than it was than at any point during the Great Recession, which is nonsense,” says Paulsen.
His expectation is that Treasury prices will fall sharply, pushing the yield on the 10-year note as high as 3.25 percent by the end of this year.
Winners. Of course, not all bonds are the same.
Junk bonds, riskier securities that pay higher yields than Treasurys, traditionally do well in a rising rate environment, says Rob Waldner, chief strategist at fund manager Invesco.
The bonds are issued by companies that have a relatively high amount of debt compared their earnings. The earnings of these companies typically rise when the economy is improving, and that offsets the impact of higher interest rates.
Junk-rated companies also tend to lock in their borrowing costs for a couple of years when they sell bonds, says Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors LLC. That means they are protected from the impact of higher rates, at least initially.
Since the start of the year, junk bonds have handed investors a 2 percent return, according to the Barclays US High Yield index, which tracks the performance of the securities.
Municipal bonds, issued by local governments, also tend to do well for the same reason as junk bonds.
“In a rising rate environment, you have good growth going on and you have good credit quality,” says Invesco’s Waldner. “High yield almost always outperforms.”
Impact on consumers
Savers. If you’re relying on savings, you'll probably welcome higher interest rates. The best rates on one-year certificate of deposits are about 1.2 percent, according to Bankrate.com. That means for every $1,000 you save, you will make $12 a year. Higher rates will boost your income.
Borrowers. As rates rise, people with large credit card balances may face higher payments. So could those looking to buy a home.
Mortgage rates, which are linked to Treasury yields, will climb should bond yields start to rise. The average 30-year mortgage rate is at about 3.7 percent, according to Freddie Mac. That compares with about 5.9 percent a decade ago and 7.9 percent in 1995.
Dave Roda, regional chief investment officer for Wells Fargo Private Bank, says that consumers should assess their finances and try to lock in their borrowing costs now while rates are still low.
“We probably won’t see rates this low again, maybe in our lifetimes,” he says.