Rising Interest Rates – What Does This Mean for Investors?

July 10, 2013:

In recent days interest rates have started to rise from the extremely low levels of the last 5 years. The Fed recently announced that it will begin “tapering” it’s $85 billion bond purchases sooner than the 2015 target date it had previously announced.  The Fed has been purchasing huge amounts of bonds since the financial crisis started in 2007 in an attempt to push interest rates lower.  Lower interest rates are a primary driver of economic growth, as the less it costs to borrow money, the more consumers and businesses tend to borrow and spend.  Increased borrowing and spending lead the way out of recessions.  The Fed’s buying pushed up the prices of bonds, especially Treasury bonds, to record high prices and low yields. Once they slow down their purchases, bond prices will fall, and interest rates will rise.

We’ve talked in the Stocks course about how markets are a discounting mechanism.  This means that they are constantly looking into the future, usually 6 to 12 months, and adjust market prices to what they see coming, not what already is.  Although the Fed has not yet slowed down its bond purchases, the markets have already priced in an interest rate hike as though they already slowed their purchases.   This is how markets work.

Although the Fed has a lot of power, ultimately it is the market that sets prices.

Let’s talk a bit about rising interest rates and what they mean for the different asset classes……….

REAL ESTATE
Rising interest rates directly affect mortgage rates. The higher mortgage rates are, the more you pay to borrow money for a loan. $100,000 borrowed at 3.5% for 30 years equals a monthly payment of $449.  However, if interest rates increase to 5%, the same 30 year loan will have a monthly payment of $536.  If you can only afford a payment of $449, then you would not be able to borrow as much money.

Mortgage rates have risen more than a full percent point from recent lows only a few months ago, catching many borrowers unaware.  Some borrowers were forced to cancel home purchases when they found they could no longer afford the house with the higher loan rate.

It is definitely a good idea to lock in a 30 year fixed rate mortgage at these low rates before they rise even further.  For rental real estate, a low loan rate can make the difference between a cash flow positive property and a cash flow negative property.

STOCKS
Rising interest rates are a headwind for stocks.  The stock market initially sold off on the Fed’s announcement, but this proved to be an overreaction, as the overall market is not within striking distance of all-time highs.  The stock market frequently overreacts in the short-term to news and events.

Many income stocks such as real estate investment trusts (REITS), business development companies (BDCs), and master limited partnerships (MLPs) took the brunt of the selloff since the Fed’s announcement.  The thinking is that these companies rely heavily on borrowing to grow, since they pay out most of their earnings to shareholders or unitholders as dividends.  Higher interest rates will dampen their borrowing, leading to less growth and therefore lower share prices.

The plus to this situation is that the yields on these income producing stocks rises as prices decline.

BONDS
Bonds are especially sensitive to interest rate changes.  Since May 1st, interest rates have risen about a full percentage point.Higher interest rates = lower bond prices. Why?  The reason is because new bonds are now issued at the higher interest rate, and this makes older bonds with lower rates worth less.  Thus, the bond’s price must be lowered to attract buyers.

Municipal closed-end funds were especially hard hit.  These funds tend to hold longer-term bonds in their portfolios, and frequently use leverage to enhance their returns.

Like with stocks, the plus to this situation is that the yields on bonds rises as prices decline.  This price decline could be a good start for building a bond portfolio, especially with municipal bonds.

GOLD AND SILVER
The precious metals, in my opinion, are most sensitive to interest rate changes when interest rates head towards extremes, both on the low end and the high end.  Since the financial crisis started, real interest rates have been negative, accounting for inflation.  With the price of almost all  assets falling, the Fed feared deflation, and this pushed them to their multi-trillion dollar bond purchases in an attempt to create some inflation.

Negative interest rates are a big plus for gold and silver.  Today, with interest rates starting to rise, the real interest rate may go back to being positive.  This will likely be a headwind for the precious metals.

Inflation beyond a normal low 2-3% level has been a positive driver for gold and silver prices.  In the 1970s inflation became a big problem, with interest rates finally peaking near 18% in 1980-81. Gold and silver rose quickly during this time and hit record highs.

The price of gold and silver have taken a big hit in recent months.  A big part of the decline is the rush out of “safe haven” assets back into riskier assets, especially stocks, and a lesser degree real estate.  With real estate coming back from the dead, and stocks making new highs in most of the indices, the precious metals have fallen into a bear market.

In conclusion, rising interest rates tend to reduce growth in all asset classes, as the cost of borrowing money increases and more capital must be devoted to debt payments.  This leads to less funds to be used for investment and  R&D.

For consumers, higher interest rates result in more money used to pay down debt.  This decreases the money a person can use for living expenses, entertainment, and investments.

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