How Do Interest Rates Affect the Economy – and Your Nest Egg?
Last week I tried to provide some calm perspective on the recent fluctuations in the markets. Again, in summary: the corrections we’re experiencing right now are perfectly normal, and not nearly as scary as some of the headlines would have you believe.
One of the main factors that’s contributing to this volatile October is the pace and expected duration of the Federal Reserve’s current rising interest rate cycle. As you probably read, President Trump wasn’t very happy with the Fed, and a lot of folks on Wall Street weren’t either. So why the rate increase? If our economy is on track for yet another positive year, why did the Fed make an adjustment that tends to spook investors and slow things down?
On today’s show, we’re following up on last week’s news to break down how changing interest rates affect the economy and various investment vehicles. Hopefully this discussion will help folks understand what the Fed’s move really says about where the US economy is as 2018 draws to a close.
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1. Watching the overnight lending rate.
Most of us have a few different interest rates in our financial pictures: mortgage interest, auto loan interest, credit card interest, and interest due to us on loans, bonds, or investments.
But the Fed controls just one rate: the overnight lending rate, which is the rate at which banks can borrow money from the Federal Reserve. All other rates are set by supply and demand in response to the Fed rate, the effects of which trickle down to things like consumer spending, the housing market, and, yes, the stock market.
2. Time to invest in the short term?
One investment that the Fed’s moves influence quite a bit are returns on buying U.S. government securities. Usually, the rate of return is higher for long-term bonds than it is for short-term bonds. Economists and financial pros keep a close eye on the relationship between these rates, because if short-term rates start to equal, or even exceed, the return rate on long-term bonds, that can be an early warning sign that we’re headed for a correction, or even an economic recession.
As we recorded this podcast, the two-year government interest rate was 2.87% and the 10-year rate was 3.17%. While past performance is no guarantee of future results, conventional wisdom says that if you’re looking to buy right now, investing in short-term securities and CDs is probably a good idea given the smallish difference between those rates. You’d only be looking at a 0.30% increase in ROI for locking up your money an extra 8 years. Plus, there’s always the chance that the Fed increases interest rates again, which may bring down the value of that longer-term bond.
3. Explore new ways to stay diverse.
At Keen Wealth, we believe that diversification and asset allocation are the best ways to reduce volatility and increase return on investment. When we’re talking about interest rates, that means holding not only government bonds but bonds with different maturities and different ratings, including municipal and corporate.
But you should also investigate how interest is – or isn’t – growing the cash that you’re keeping in the bank. Unfortunately, when interest rates go up, banks are often pretty slow in raising the rates they pay on savings, CDs, or money market accounts.
Now might be a good time to shop around and see what kind of rates are available at other local banks or credit unions or even online lenders to see who might be offering better rates. If your banking is mostly auto-deposits and ATM runs, visit your local branch for a face-to-face. Play a little hardball! If your current bank isn’t going to help you build more wealth, there are plenty of others that will welcome your business. Sometimes “chasing rates” can be a hassle, so it isn’t always practical, but having the conversation with your banker at this time might make sense.
4. Higher is still (historically) lower.
A “rate hike” sounds drastic, but just looking back on my 25-plus years in financial services, our current interest rates are still low by historical standards. That’s a reflection of an economy that’s chugging along nicely despite the uncertainty surrounding next month’s elections, the US and China butting heads over trade, and the recent market volatility. By raising interest rates, the Fed is basically saying, “Things are good! Now put some money in the bank and spend a little less so inflation doesn’t get out of control.”
The last thing I want to say about the rocky month we’ve had is that when I’m advising you that these fluctuations are normal, it’s not because I’m indifferent to how unsettling market volatility can be to investors, especially if you’re nearing retirement age. On the contrary, my team at Keen Wealth understands that your family’s wellbeing is tied to how we navigate these important issues. And we don’t want to see folks overreact to market fluctuations, panic, and make mistakes from which your finances might not have time to recover.
So the next time market volatility or a controversial move by the Fed makes you nervous, try to keep your eye on the big picture like we do at Keen Wealth. And if you need a little extra reassurance or advice, turn off cable news, close Facebook, and come talk to one of my fiduciary advisors.
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Bill Keen is a CHARTERED RETIREMENT PLANNING COUNSELOR℠ and independent financial advisor with more than 25 years of industry experience. As the founder and CEO of Keen Wealth Advisors, a registered investment advisory firm, he specializes in providing personalized retirement planning designed to help people thrive before and during their retirement years. With a passion for educating others, Bill regularly blogs about retirement planning, hosts the podcast Keen on Retirement, and has contributed to U.S. News and World Report, Reuters, Wall Street Journal’s Market Watch, Yahoo Finance, and other publications. Based in Overland Park, Kansas, Bill and his team work with clients throughout the greater Kansas City area and across the nation. To learn more, connect with him on LinkedIn or visit www.keenwealthadvisors.com.
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