Who wins and who loses when the FED finally decides to raise interest rates?

Who wins and who loses when the FED finally decides to raise interest rates?
Eileen St. Pierre, The Everyday Financial Planner

128px-US-FederalReserveSystem-Seal_svg.pngThe debate finally seemed settled. All the Federal Reserve (FED) watchers predicted the FED will finally raise interest rates in June. Then we got some lackluster economic data and now they say the FED may wait a little longer. Will the FED go ahead and raise rates already? Let’s get it over with.

Don’t expect the seas to part when it finally happens. It will be a small increase, about 25 basis points (100 basis points = 1%). That’s only 0.25%. Who wins and who loses when interest rates go up?

The Winners

Savers who want a safe place to put their money will win. Interest earned on savings and money market accounts will go up. Retirees on a fixed income should not get too excited just yet.

  • If you have $10,000 sitting in a money market account and interest rates go up 0.25%, you’ll earn an extra $25 a year.
  • You may just earn enough interest to finally start receiving a 1099-INT form from your financial institution.
  • But the hope is that this is just the start of increasing long-term rates of return.

Rising interest rates will also cause the value of the dollar to rise. The dollar has already risen to record levels, perhaps in anticipation of an interest rate increase (Washington Post). The rising dollar benefits Americans vacationing abroad. It’s a good time to go to London to catch a glimpse of the new royal baby.

The Losers

New borrowers will have to pay more for loans. Those who already have adjustable rate loans will see their rates adjusted upward. Make sure you read your loan agreement to see when your payment is reset and the formula for determining your new payment.

In the short run, holders of bonds and bond funds will see bond values fall. Generally speaking, there is an inverse relationship between interest rates and bond prices. When interest rates rise, bond prices fall. How much they fall depends on the bond’s duration. Bond fund holders should look for the fund’s average duration.

The Importance of Duration

Duration measures the sensitivity of a bond’s price to changes in interest rates. The longer the duration of the bond, the larger the price decline when interest rates rise. Let’s continue with our example of an interest rate increase of 0.25%:

  • A bond fund with an average duration of 8 years will experience a price decline of around 2%.
  • If you invest in a shorter duration bond fund – say 4 years – the price will only decline by about 1%.

In the long run, bond investors should experience higher rates of return. Companies and governments will issue new bonds at the higher rates. This will allow investors to earn higher rates of interest.

The Stock Market

It’s unclear how the stock market will react. It seems that whenever the FED delays raising interest rates, the stock market goes up. But rising interest rates mean the economy is strong enough to handle it. That should be a good thing. Don’t expect the rollercoaster ride to end.

For more Investing Basics, visit my Basic Financial Management page.