The Federal Reserve Board (Fed) has kept short term interest rates near zero for several years. Large banks were able to borrow at near zero rates and lend at higher rates for home mortgages, and for automobile buyers and for businesses. The Fed governors intended to increase interest rates when inflation approached their discomfort level (about 3%) and when unemployment reached 6.5%. Unemployment is 6.1%, beyond the Fed’s original goal, partly because so many people dropped out of the labor force.
A consensus of financial market watchers think the Fed will start hiking interest rates by midyear 2015. The Chicago Mercantile Exchange estimates there is a 2/3 chance that the Fed Funds rate will be 0.5% or higher on July 29th 2015. When the Fed acts, it will likely use a series of small steps, selling bonds from its portfolio at a pace that increases interest rates a half or quarter point every few months until inflation is pushed down to a tolerable level.
Higher interest rates will dampen business investment and job creation and will gradually increase the payments government owes on its hideous pile of national debt. The government and the macro economy are not alone feeling interest rate impacts. Ordinary consumers will take a hit if we are not nimble. We may be unable to sidestep tax increases that the government may adopts to keep pace with debt interest payments, but we can adjust our interest-sensitive investments, averting pointless losses.
What follows are merely observations on market forces – they are not recommendations to buy or sell any assets.
We should avoid devaluation of our assets. Higher rates will decrease the value of our bonds and CDs. Those who did not want to manage their portfolio through interest rate changes have already bought TIPS (treasury bonds with imbedded inflation protection), even though they offer exceedingly low yields.
Ideally, some will sell bonds while rates are still low and buy bonds when interest rates have peaked. The timing of such actions may need adjusting to avoid holding cash (zero yields) for an excessive period. Others might avoid the brunt of interest rate effects, but to some extent the anticipated Fed actions are already imbedded in bond and share market prices.
A similar sell-hold-buy strategy applies to Real Estate Investment Trusts, Master Limited Partnerships, and Business Development Companies, because their share (or unit) values are closely coupled with prevailing and anticipated interest rates.
The ideal timing for annuity purchases is very sensitive to interest rates due to interest compounding over long time periods. Many of us recoil at the specter of hearing another high pressure sales pitch, and even worse, the realization to much of an annuity’s so-called “yield” is the return of your own principal, however for some of us circumstances have changed for the better.
A few days ago, the IRS’s adopted a rule on longevity annuities within IRAs. Now IRA owners can hold a longevity annuity (an annuity that starts at a future date and pays until death) inside an IRA without violating the required minimum distribution regulations. If the annuity owner dies during the deferral period, the full premium is returned to his estate. This is very helpful to retirees who are concerned about running out of money in late retirement (e.g. at age 85 and beyond). Now you can use pre-tax money to buy the annuity.
A twenty-year deferral can turn a modest premium into a substantial recurring income. For example, a 65-year-old man who wants $1,500 monthly income would pay $272,000 for a single premium immediate annuity, but only $52,000 for a longevity annuity starting at age 85.
The upcoming interest rate increases are another reminder to refinance your home mortgage, if rates are significantly lower than your current mortgage rate. Mortgage rates won’t stay low for very long. Many consumers have already taken advantage of the refinance opportunity. One caution — if you plan to sell the home in the near future, the transaction costs of remortgaging may overwhelm any interest savings.
This blog is not intended to provide financial investment advices, but only to provide examples of how economic factors can have a direct impact on your financial standing. While we cannot control interest rates, we can control much of the damage they could do to our assets. By monitoring the Fed’s interest rate actions, we can earn a large payoff. Consumers are savvy enough to understand the decisions the face, especially with help from a fee-only financial counselor.
Alan Daley is a retired businessman who writes for The American Consumer Institute Center for Citizen Research