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Updated on Monday, December 7, 2020
The federal funds rate is the interest rate banks charge one another for overnight loans, and it is determined by the Federal Reserve’s Federal Open Market Committee (FOMC). A Fed rate hike increases the cost of funds for banks — a cost they ultimately will pass on to their customers, both individuals and businesses.
A Fed rate hike invariably leads to an increase in the prime lending rate, which often leads to an increase in interest rates for both consumers and businesses. Beyond the obvious impact on borrowers and credit card holders, higher borrowing costs can ripple through the rest of the economy, including to your investments.
What a Fed rate hike could mean for your investments
Rising interest rates impact most areas of the economy — including your investments. Here’s what to look out for.
Stocks and bonds
Bonds move inversely with interest rates. When rates rise, all things being equal, the price of existing bonds will decrease. Those investing in individual bonds could see the price go down. If the bond is held until maturity, investors will receive the full value of the bond. If they need to sell the bond prior to maturity, they may receive a price that’s lower than it would be if held until maturity.
Bond mutual funds and exchange-traded funds (ETFs) are impacted in a similar way but with a key difference. Since they are portfolios of bonds, the funds themselves never mature. An interest rate hike could reduce the value of the bonds held in the funds.
The impact on stocks, stock mutual funds and ETFs is a bit harder to gauge. Rising interest rates can lead to higher borrowing costs for many companies, which could impact the profits of companies who rely heavily on debt financing.
Rising rates also could hurt the revenue of companies whose business is dependent upon customers’ ability to borrow money, such as automobile manufacturers or homebuilders. Depending on how much stock of these companies you own or how prominently they are represented in ETFs and mutual funds you own, the impact could be adverse.
If interest rates rise, the residential real estate market also could be impacted. Higher mortgage rates impact buyers’ ability to borrow. This could serve to decrease the demand for housing, driving down prices. Besides prospective homeowners, this could impact those who invest in income-producing properties.
Similarly, the price of commercial real estate could see a decline if interest rates drive up the cost of loans to purchase commercial property. If financing is harder to get or the cost of borrowing is too high for some buyers, it could serve to drive real estate values down.
Real estate investment trusts (REITs), which own or finance various types of income-producing properties, also may suffer in value in a period of rising interest rates. There are many publicly traded REITs, which are essentially stocks, and many mutual funds and ETFs invest in REITs.
Rates for savers
Savers who use vehicles like CDs, money market mutual funds and other types of saving accounts could see an increase in the interest rate they earn when investing in these types of vehicles and accounts.
This provides a better return on these relatively low-risk savings vehicles. That could give a much-needed boost to investors who keep funds in these types of accounts, whether as a parking place for emergency cash or as a safe spot to stash a portion of their retirement savings.
Money held in your IRA and 401(k) accounts likely would not be impacted by rising rates, simply because of the structure of the accounts. However, as mentioned above, the investments held in these accounts could be impacted, potentially reducing the value of your retirement savings.
Recent changes in the fed funds rate
In December 2020, the federal funds rate range stands at 0% – 0.25%, the result of two massive Fed rate cuts in March in response to the coronavirus pandemic. To support the economy, the Fed has put the federal funds rate on its backburner and turned to its other tools like issuing business loans and buying up securities.
The last time the Fed raised the federal funds rate was back in December 2018, leaving the rate range at a high of 2% to 2.25%. The rate rose gradually from near zero in the years directly following the financial crisis of 2007, when the Fed kept rates low to help the economy recover.
Where are interest rates headed in 2021?
We will likely see a similar pattern as the economy rides the waves of the pandemic. In the Fed’s September Summary of Economic Projections (SEP), members indicated they expect the next Fed rate hike to come in 2022 or 2023. Consumer interest rates on deposit accounts and loans will likely continue the downward trend in 2021 that they set in 2020.