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Our Thinking

Are You Ready for Rising Interest Rates?

Andrew Goldberg, William Huzar, Jacob Manoukian, and Madison Faller

Are You Ready for Rising Interest Rates?

The yield on 10-year U.S. Treasury bonds recently reached the neighborhood of 3%, its highest level since 2011. What do these higher interest rates mean to you? Why should you care? And what’s the impact on your investments?

 

 

IN BRIEF

After years of unusually low interest rates following the financial crisis, rates have been gradually on the rise. With the Federal Reserve expected to continue to raise rates in coming years, investors and borrowers need to prepare for an environment that’s not been seen in more than a decade.

Why should I care about rising interest rates?


The ability to borrow money is like oxygen for the economy and, in turn, the stock market, job market and other aspects of your financial life. Companies and consumers take out loans to build factories, buy homes and make major purchases. As interest rates rise, and the cost to borrow increases, investment may decline, slowing the economy.

 

You may feel the effect of this in your investment portfolio. If the cost to borrow becomes too high, economic growth may falter to the point where stocks become less attractive to investors.

 

 

Where have rates been recently?


Low, really low. In response to the financial crisis, the Federal Reserve pushed down interest rates to near zero to stimulate more borrowing and pump more money into the struggling economy.

 

As the economy has improved in recent years, the Fed put the brakes on its stimulus plans and began to raise rates.

 

 

Federal Reserve policy interest rate (Fed Funds rate)

Federal Reserve policy interest rate (Fed Funds rate)

Sources: Federal Reserve, Haver Analytics.

Data is as of April 30, 2018.

Today, despite six Fed hikes since 2015 and several more expected this year, rates remain low by historical standards.

 

Why have rates been rising?


A few reasons. Let’s rewind to September 2017 when 10-year U.S. Treasury yields stood at roughly 2%, a level consistent with low growth and minimal inflation. Since then, investors have begun to factor in a more robust economy, the benefits of new tax reform, a larger budget deficit and future Fed hikes. The result: Rates have risen to around 3% neighborhood.

 

 

Where will rates go from here?


Higher—but gradually. Based on our expectations for strong global growth and healthy inflation, we think rates will continue to slowly drift higher, ending 2018 at around 3.1%. We anticipate that the Fed will raise rates a total of four times this year—and two to four times in 2019.

 

 

What happens to bond prices as rates move higher?


As interest rates rise, bond prices fall…but not by equal amounts. Some bonds are more sensitive to rate movements than others, a concept known as “duration.”

 

When rates rise, bonds with higher duration will suffer bigger price declines. For example, bonds with longer maturities tend to have more duration risk. Some bonds, however, will weather this storm better and may even benefit from higher rates. Floating-rate notes, in particular, can help protect investors from losses because they pay higher yields as interest rates rise.

 

 

How should I invest in bonds now?


We suggest a diversified approach, taking advantage of today’s higher rates and flatter yield curve by combining short-term, floating-rate instruments with opportunistic longer-term securities. Unconstrained bond mutual fund managers also have broad flexibility to navigate the current environment without the restrictions of traditional rate-driven benchmarks. Overall, it’s especially important to understand how much duration you have in your portfolio and how higher rates could affect it.

 

 

Why should I own bonds at all?


Diversification, to name just one reason. If the economy were to unexpectedly weaken or some other development caused stock prices to fall, bonds could rise in value to help cushion the loss. As we saw during the financial crisis, a diversified mix of both stocks and bonds declined less and recovered faster than an all-stock portfolio.

 

 

What else do rising rates affect?


Personal loans. Investors who borrow against the assets in their portfolios or hold adjustable-rate mortgages typically have to make bigger loan payments as interest rates rise. That can leave less money for shopping, traveling, saving and other priorities.

 

Economic growth. Increased borrowing costs can slow down the economy. Not only are current borrowers burdened with higher interest costs, but future borrowers may be discouraged from borrowing as costs rise.

 

Stocks. If investors sense a slowdown in growth due to rising interest rates, their pessimism could spread to the stock market. Bonds may start to seem like the better investment if rates continue creeping upward. Bonds are generally less volatile than stocks, which may make them more attractive in an environment where future growth looks uncertain.

 

 

What should I be watching next?


The Federal Reserve. A healthy U.S. economy and robust global growth should spur the Fed to continue raising rates. While we don’t anticipate a meaningful spike from here, we do expect rates to rise in a gradual manner. This ongoing move higher will impact the price investors are willing to pay for stocks, the market value of bonds and the yields paid on floating-rate notes. Investors should continue to monitor both their assets and liabilities to determine the best way to navigate today’s rising-rate environment.

 

 

Not all investment ideas referenced are suitable for all investors. Investing involves market risk, including the possible loss of principal. There is no guarantee that investment objectives will be reached. Diversification does not guarantee a profit or protect against a loss.

 

Opinions and estimates offered constitute our judgment as of the date of this material and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described herein may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

 

© 2018 JPMorgan Chase & Co.

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