Plus Best Yields Now for Savers
Since the Federal Reserve started raising interest rates in December for the first time in nearly a decade, many savers and borrowers have been wondering how the long-awaited shift might affect them.
Bottom Line/Personal turned to top investment manager Ted Peters, a former Federal Reserve regional board member, for answers…
Big banks have been quick to raise the interest rates that borrowers must pay on loans since the Fed acted, so does that also mean that savers will receive more interest on their savings and money-market accounts and certificates of deposit?
Unfortunately, no. Wells Fargo, one of the biggest banks, took just 12 minutes after the Federal Reserve acted to start charging more on some loans, and other major banks soon followed. But not one of them to date has meaningfully increased the annual percentage yields (APYs) that it pays on FDIC-insured deposit accounts or CDs.
How can banks get away with that from a business standpoint?
The Federal Reserve doesn’t control what banks charge for loans or what they pay for deposits. And creating a spread between those two figures is the way banks make most of their money.
Back in 2006, when the last rising-rate cycle began, banks passed along just 17% of the increase in Federal Reserve rates to depositors over the next year. The gap could be even more extreme this time because big banks don’t need to attract a lot more in deposits. They’re already flush with cash from risk-averse investors.
That said, consumers who shop aggressively can find far more generous yields at Internet-only banks, which are still looking to grow fast, and at credit unions, which are owned by their members and tend to be more generous. (See Bottom Line Personal’s Best Places for Your Cash Now.)
What about CDs?
It’s true that CD yields tend to move up more quickly in reaction to Federal Reserve rate hikes, but they still are too low to justify getting a five-year or longer CD.
I would avoid locking up any money in CDs for more than one to two years, because a spike in inflation or other unexpected event could push up rates on new CDs sharply in the next few years. It’s not worth the risk.
With rates on loans already rising, do consumers need to act quickly to buy a home, refinance a mortgage or look for lower interest rates on credit cards?
It depends. If you have an adjustable-rate loan tied to the prime rate, it typically will rise in sync with Fed moves. These include variable-rate credit cards, home-equity lines of credit (HELOCs), private student loans, many auto loans and adjustable-rate mortgages (after the initial fixed-rate period ends). Consider looking for better deals before rates rise further.
The consumer financial information website Bankrate.com expects the average credit card variable interest rate to hit 16.5% this year, up from 15.7% in January 2015. HELOCs could top 5%, and loans on cars could hit 5%, on average, for new ones and 6% for used ones.
Higher interest rates also will mean fewer promotional offers for credit card transfers. For example, if you have a good credit score and want to transfer your credit card balance, a card issuer might offer an introductory interest rate of 2% instead of 0%. And that rate might be available for just 12 months instead of 18.
However, interest rates charged on new fixed-rate home mortgages are likely to rise more slowly. Bankrate predicts a 30-year mortgage interest rate of 4.5% by the end of 2016, up from 4.05% recently and as low as 3.79% last April.
Bond-fund investors are worried that higher interest rates will cut into their returns, possibly even resulting in losses. Is that likely?
Yes. They could suffer big losses as rates rise—but not always for the reason most investors think. Higher yields on newer bonds that a fund buys can make up for some of the loss in share price that occurs when existing bonds lose value as rates rise. But that masks a darker risk. If investors get nervous and sell their bond-fund shares, the fund managers could be forced to liquidate their better investments in order to meet redemptions, causing fund values to drop sharply because the remaining bonds are of lower quality. Conservative investors should either switch to individual bonds and hold them to maturity or buy funds with an average duration (a measure of interest rate sensitivity) of less than two years, which means that they would experience less share fluctuation.
What about the economy? It still doesn’t seem very strong. Won’t higher interest rates slow down consumer spending and trigger a recession?
That’s a possibility. In 2011, European central bankers raised interest rates twice and cut off the economic recovery there. It’s difficult to predict the timing and impact of higher interest rates on an economy. In past rising-rate cycles in the US, recessions have come as quickly as 11 months after the first rate hike and as long as 86 months. For the next few years, I think our economy can easily handle higher rates—and a slow, steady economic expansion in the range of 2% to 3% per year can continue. I expect oil prices, inflation and unemployment to remain low, and that means consumers are likely to keep spending.
What about the stock market? Will some sectors fare much better than others?
Yes. The stocks of banks and other financial-services companies are likely to do well because higher loan interest rates will dramatically improve their profit margins. Plus their stock valuations still are reasonable.
The stocks of many small and midsize banks, which have really suffered in the low-rate environment, are bargains. Bank of the Ozarks, LegacyTexas Bank and New Jersey–based Sun National Bank are among the most attractive. The consumer discretionary sector and the technology sector also are attractive. These two sectors have historically outperformed when rates were rising and the economy growing.
Avoid emerging-market stocks. A rise in US interest rates can cause serious problems for developing economies. Higher rates make it more expensive for overseas borrowers to service their massive dollar-denominated debts.
Also avoid energy stocks, even though in past rising-rate cycles, this sector has been one of the better performers. It’s true that energy stocks have plunged, and they may look like real bargains. But it’s still risky to bet on a major turnaround in 2016. The energy sector’s collapse has been driven by conditions that are likely to persist this year, including a glut in global oil supply, an economic slowdown in most of the world and a stronger US dollar.