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The Fed Raised Interest Rates – Now What?

If you’re being bombarded by news of the Federal Reserve raising interest rates and you’re feeling as if you need to do something – stop! Many times in investing, doing nothing is a whole lot better than doing something.

First off, what did the Fed actually do? Federal Reserve chairwoman Janet Yellen, along with the Fed’s board of governors, voted to raise the Federal Funds target rate from 0% - 0.25% to 0.25% - 0.5%. The Fed Funds rate is a range in which banks charge other banks for overnight loans. The rate is important as it is the basis for many other rates such as the one that you earn on your deposits in your bank. Still, the move from basically zero to essentially zero is not earth-shattering. The implications for an investment portfolio at this magnitude are not drastic, although advisors and others interested in getting their hands on your money will tell you otherwise.

The Federal Reserve Bank of Cleveland

As interest rates go up, bond prices will come down. When it comes to stocks, however, there are many other factors that come into play. This recent rate increase was perceived as an endorsement of the U.S. economy by the Fed and had been essentially guaranteed for over a year now. Everyone knew it was coming; it was just a matter of this month or next month. Slight and gradual increases in rates towards normalcy will not necessarily cause stock prices to fall. As previously mentioned, they will likely be perceived as more of an effect of a healthy economy, which causes the demand for money to increase and interest rates to increase as a result. Bond prices will undoubtedly fall, however, as they are fixed income instruments. Their cash flows are predetermined. If new bonds come to market and offer a higher interest rate all else equal, you pay less for that bond than you would have previously in a lower interest rate environment.
The prices of your bonds will fall as interest rates increase, but interest rates do not determine the absolute cash flows. All else equal, the same number of dollars will keep coming in. You could invest those cash flows at higher rates. If you want to sell those bonds, however, then you will take a hit. As rates rise, one of the best things you can do is to shorten the duration of your portfolio or essentially the lifetime of your bonds. If you own longer-term bonds, you will earn a relatively lower interest rate for a longer time. If you own shorter-term bonds, you earn that lower rate for a shorter time and are able to get your principal back faster and invest it at ever growing rates.

In a stable economy, increasing rates can be a signal that money is in high demand and benefit financial institutions such as commercial banks. These banks can make loans and earn higher interest on them compared to the ultra-low rates they have earned on mortgage lending for going on a decade now. Savers, those who have deposits with those banks, can also make out as they earn more interest on their deposits. Thus, taking a look at some of the best banks and other financial institutions could be prudent going forward if the economy remains at cruising speed or better – picks up speed in 2016. Still, there are many worries for the U.S. and world economy, but we will explore such issues in future articles.

In the meantime, take a deep breath and do not feel that you have to buy this or sell that like many in the financial media would have you believe. Repetitive actions like trading are the enemy of the everyday investor and will eat into your returns. Take heed to Warren Buffett and invest in great companies regardless of the interest rate environment, economic environment, or any other factor out of your control. Time is the friend of the astute, patient investor.

- Andrew Sebastian

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