May 17, 2022
The Federal Reserve recently announced that it’s raising interest rates by half a percentage point — the biggest increase to short-term borrowing costs in more than two decades — and alerted consumers that more hikes of this size are yet to come, marking the U.S. central bank’s most aggressive moves yet to contain the highest inflation in 40 years.
The move from The Federal Open Market Committee (FOMC) of bumping the federal funds rate to a target range of 0.75-1.00%, follows an increase of 0.25% in March, as the Fed continues reducing liquidity to the financial markets to help tamp down soaring inflation.
The central bank also announced that it was further reducing stimulus to financial markets by letting its holdings of bonds decline over time. The Fed will work its way up to letting about $95 billion in bonds roll off its balance sheet every month, reducing liquidity by about $1 trillion per year.
The Fed’s move comes as inflation rages in the U.S. economy at the highest annual rate in some 40 years, hitting 8.5% in March. With the Fed hitting the brakes on an overheated economy, the main question for many market watchers is how fast Federal Reserve Chairman Jerome Powell & Co. will continue to raise rates.
“The Federal Reserve is behind the curve on inflation and has a lot of catching up to do,” said Greg McBride, CFA, Bankrate chief financial analyst. “This means rate hikes at successive meetings for the first time in 16 years, and for the first time in 22 years, a larger half-point hike.”
At about 3%, the 10-year Treasury bond is now at its highest level since late 2018, as markets price in the expectation of sustained inflation and rising rates. After some ups and downs in 2021, the benchmark bond has soared since December 2021 and especially since the start of March, when it sat at just 1.65%.
As the Fed embarks on what appears to be a longer period of raising rates, here are the winners and losers from its latest decision.
While the federal funds rate doesn’t really impact mortgage rates, which depend largely on the 10-year Treasury yield, they’re often moving the same way for similar reasons. With the 10-year Treasury yield zooming higher in recent months, as the market prices in expectations of the Fed raising rates, mortgage rates have risen alongside them.
“Mortgage rates have bounded higher by 2 full percentage points since the end of 2021, one of the largest and fastest run-ups in history,” McBride said. “Mortgage rates move well in advance of Fed action and the outlook for inflation and the economy will be the key determinants of what we see with mortgage rates in the months ahead. Until we see signs inflation has peaked, the risk is definitely to the upside.”
The run-up in rates – following the rapid rise in housing prices over the past couple years – has created a double whammy for potential homebuyers. Home prices are more expensive and the financing is pricier, resulting in a slowdown in the housing market.
So would-be homebuyers are worse off by the rise in rates. Here’s how to find the lowest mortgage rates today.
The cost of a home equity line of credit, or HELOC, will be ratcheting higher, since HELOCs adjust relatively quickly to changes in the federal funds rate. HELOCs are typically linked to the prime rate, the interest rate that banks charge their best customers.
Those with outstanding balances on their HELOC will see rates tick up, though interest expenses may continue to be low historically. A low rate is also beneficial for those looking to take out a HELOC, and it can be a good time to comparison-shop for the best rate.
But with rates moving higher, even a little bit, and the expectation that they’ll move higher still as the year progresses, those with outstanding HELOC balances should expect to see their payments continue to rise in the near term. (Here are the pros and cons of a HELOC.)
Many variable-rate credit cards change the rate they charge customers based on the prime rate, which is closely related to the federal funds rate. The Fed’s decision means that interest on variable-rate cards will move higher now.
“Credit card rates will march higher in step with the Federal Reserve, and often follow within one or two statement cycles,” McBride said. “Pay down credit card debt now because it will only get more expensive and you don’t want that debt hanging over your head, should the economy topple into recession.”
If you have an outstanding balance on your cards, then you’re going to get hit with higher costs. With rates projected to rise for a while, it could also be a welcome opportunity to shop for a new credit card with a more competitive rate.
Low rates on credit cards are largely a nonissue if you’re not running a balance.
Savings accounts and CDs
Rising interest rates mean that banks will offer increasing returns on their savings and money market accounts, but will likely adjust their yields at a measured pace.
Account holders who recently locked in CD rates will retain those yields for the term of the CD, unless they’re willing to pay a penalty to break it.
Those with savings accounts may look forward to rising rates, but it’s off a low base, as most banks quickly ratcheted rates to near zero following the Fed’s emergency cuts in March 2020.
“Yields on certificates of deposit have started to pick up and we’ll see the same in savings yields, although with a bit of a lag,” McBride said. “The outlook for the next year or so is much better than what savers have endured over the past three years, where rates fell and then inflation took off.”
“It will take a while, but as rate hikes continue, the returns savers get will rise and inflation will hopefully decline,” he said.
Savers looking to maximize their earnings from interest should turn to online banks, where rates are typically much better than those offered by traditional banks.
Stock and cryptocurrency investors
A huge boon for the stock market has been the Fed’s willingness to keep rates at near zero for an extended period of time. Low rates have been beneficial for stocks, making them look like a more attractive investment in comparison to rates on bonds and fixed income investments such as CDs. But that’s changing.
In the last few months, investors have been pricing in the potential for rate increases, with the S&P 500 starting 2022 in a deep slump.
“The market went up with little hesitation while the Federal Reserve was pumping stimulus into the economy, but now that they’re removing that stimulus, market volatility has returned,” McBride said. “Particularly susceptible have been the high-octane growth stocks that were the primary beneficiaries of low interest rates, with investors now questioning what value to put on those stocks in a higher interest-rate environment.”
Cryptocurrencies have also been feeling the brunt since November, when the Fed more clearly telegraphed its intentions to reduce liquidity in the financial system. Bitcoin, Ethereum and other major cryptos are well off their 52-week highs and have shown a solid downtrend over the last few months, as they priced in reduced stimulus and the potential for higher interest rates.
The Fed’s reduction in its own bond portfolio should further decrease support for stocks and crypto.
The U.S. federal government
With the national debt above $30 trillion, rising rates will raise the costs of the federal government as it rolls over debt and borrows new money. Of course, the government has benefited for decades from a secular decline in interest rates. While rates might rise cyclically during an economic boom, they’ve been moving steadily lower long term.
For now, the interest rates on debt remain at historically attractive levels, with 10-year and 30-year Treasurys running well below inflation. As long as inflation remains higher than interest rates, the government is slowly taking advantage of inflation, paying down prior debts with today’s less valuable dollars. That’s an attractive prospect for the government but not for those who buy its debt.
Inflation has been hot much of the last year, and the Fed is raising interest rates to combat it. But rates still do remain low by historical standards, at least for now, so it makes sense to think about how to take advantage, for example, by being more discriminating when it comes to shopping for rates on your savings accounts or CDs.
(Sources: Bankrate.com, The Wall Street Journal and The Spokesman-Review)