How a US interest rate rise could affect your investments

by from interactive investor |

This week is meant to be when the UK government gets EU clearance to move Brexit discussions to phase two. The green light is clearly progress, but talks to decide a future trade framework will have more twists and turns than this initial preamble.

Securing a successful deal with our biggest trading partner can only be good for general investment sentiment. The transitional period may complicate matters, but at least corporate investment plans put on hold may be resurrected.

But before Jean-Claude Juncker hands Theresa May an early Christmas present - and ahead of a likely no change to monetary policy at both the Bank of England and European Central Bank tomorrow - US central bankers take centre stage Wednesday evening as policymakers declare their current view on interest rates.

The Federal Reserve's rate decision is arguably the most prominent event on the US economic calendar.

The tightening phase should gain momentum this month, with the vast majority of economists polled expecting a quarter percentage point rate rise, largely due to a tight labour market and robust economic growth in 2017. This will represent the third interest rate hike in 2017 and will take the benchmark federal funds rate to a range of 1.25% to 1.5%.

A Reuters poll indicated that three more rate rises are priced in for 2018, arguably reflective of a need to further tighten monetary policy against a backdrop of tax cuts and any associated increase in national debt. This process naturally needs to be balanced against weak inflationary pressures, which have undershot the Fed's 2% target rate for over five years.

It is important to remember that this relatively recent change in direction is maybe more about reversing an ultra-accommodative stance and effectively normalising rates. This neutral level would neither stimulate nor inhibit economic growth and Fed rhetoric would suggest this is around the 2.75% level.

In this sense, the Fed can theoretically hike without dampening growth. However, there is also a degree of economic cynicism here. By raising rates back to a 'normal' level, the Fed will have more breathing room in the event of another recession i.e. reducing the funds rate to stimulate growth. Although a new Fed chair and a reshuffle in board members is imminent, a change in direction anytime soon is a remote possibility.

Having assessed the implications of the Bank of England's interest rate decision in a previous article, we will be re-visiting familiar territory when considering the Fed.

At a most basic level, monetary policy affects the US economy in terms of the availability of money, and the associated debt servicing costs will drive access to credit. Increasing rates encourages saving and the monetary supply will theoretically contract.

Higher interest rates should attract foreign inflows, thus leading to a strengthening dollar. Lower interest rates encourage borrowing on both a corporate and individual level. The lower cost of debt should drive spending and consumption which is positive for economic growth.

Any change in the fed funds rate will filter through to interest rates offered by banks and other financial institutions. On a broader level, this will change the macro backdrop and influence the spending decisions of households and businesses. Economic growth, employment and inflation will all be impacted by such changes.

The fed funds rate is typically positively correlated with short-term interest rates i.e. they will rise and fall together. This will affect the rate of return paid to holders of US Treasury bills and commercial paper issued by private corporations. This will ultimately influence medium- and longer-term interest rates such as fixed-rate mortgages and consumer loans.

If there is a perception that a tightening phase now is likely to lead to much higher medium-term rates, this could spell bad news for people looking to remortgage or refinance credit card loans. Simply put, medium-term rates are likely to have a big interest rate premium as compared to their short-term counterparts.

For investors, a change in the fed funds rate can impact their portfolio. Fixed income products tend to have an inverse relationship with interest rates i.e. rates go up, the price of bonds usually fall. Longer-dated bonds tend to be more sensitive to interest rate changes, a relationship known as duration risk.

Equity prices are likely to be affected too as a decline in longer-term interest rates may drive equity inflows and an upturn in the stockmarket. Lower interest rates may also be considered in terms of the economic stimulus they provide to corporations. This potential for greater investment and higher profits could lead to a rally in equities.

We discussed imports and exports in the context of last month's Bank of England interest rate decision. Lower interest rates will make the yield on dollar assets less attractive, thus reducing international demand. Any associated dollar weakness could increase the demand for US exports. With the cost of imports for US residents rising, domestic companies may receive a boost.

The converse is typically the case for higher interest rates and a dollar rally could lead to a growth in imports, a fall in exports and reduced domestic consumption.

The effects on personal consumption have been well-documented, but an easing in monetary policy should see a corresponding rise in the purchase of durable goods (TVs, mobiles, etc.). The housing market should similarly benefit with an increase in house purchases and mortgage approvals.

Producers' costs may be influenced depending on the nature of the business. For example, any savings in financing costs may be passed on to the consumer. However, a company reliant on imported factors of production may have to raise prices to remain profitable if the dollar weakens under looser monetary policy.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.