NEW YORK (CNNfn) - It's a merry little merry-go-round. Now that the Fed has raised interest rates a quarter point, the big question is: What will they do next?|
"What does that mean for me?" isn't a bad bottom line to bear in mind, though it can be mighty dizzying to watch that interest-rate wheel keep spinning.
Wall Street certainly thinks rates are going to go higher later this year. "I believe they are going to raise rates at least twice more after today," said Bruce Steinberg, chief economist at Merrill Lynch. Steinberg envisions a quarter-point increase at both the Fed's March and May meetings, meaning the Fed Funds rate would move from 5.5 percent before today's raise to 6.25 percent after May.
Most analysts on the Street share his sentiments. Ahead of today's 0.25 percent hike in the federal funds rate, fed funds futures showed that the finance world expects rates to rise by 0.75 of a point by June. The yields on short-term bonds are higher than on the long-term, benchmark 30-year Treasury. That's a sure sign that bond traders expect higher rates sooner rather than later, and that they expect the Fed's strategy will end up cooling the economy longer term.
So what's in it for me?
All well and good. Knowing that Wall Street expects interest rates to pop a couple of times is nothing but handy cocktail-party trivia for most mere mortals. An interest rate hike whips the market in frenzy, but it leaves a lot of regular investors nonplussed. What will a series of increases mean for everyday people?
Steinberg himself admits the effects are hard for non-Wall Street-types to fathom. "What does that do; that's a pretty broad question," he said.
Of course, investors notice the market effects immediately. They're likely to have noticed them ahead of time because anticipated rate hikes get built into the market. On Tuesday, stocks rose strongly because the Fed seemed ready to raise rates, but not too aggressively. Today's announcement also prompted a short rally. To make matters more complicated, sometimes the market applauds the Fed for raising rates in pre-emptive moves. Confused?
Strong stomachs needed for choppy waters to come
Higher rates hurt the stock market. But how much will they hurt it? For Steinberg, the uncertainty over how many times the Fed will raise rates, coupled with the feeling that they will, means the market will rip apart each new economic indicator for signs of what the Fed will do.
"Until those [signs] are clearer, the markets will remain very, very nervous. You will need a strong stomach over the next few months if you're an investor," he said.
The lack of direction will make it hard for the market "to get any traction going," he said. "Volatility is likely to continue to be very great." There will be buying opportunities in the periodic declines. Steinberg thinks that the second part of the year will start to look better for stocks, and that the Fed should accomplish the slowdown it's looking for by the end of the year.
But already, the market has not been kind to many non-technology stocks, which have already gone through significant corrections. That means the downside is limited, Steinberg said.
Techs might take a beating
Normally, stocks with high price-earnings ratios suffer the most from rising interest rates. Investors work out today's valuations for stocks by discounting their future cash flow back to now. The higher interest rates rise, the steeper the discount back to today, meaning the lower the price should be today. And higher interest rates cramp the styles of companies that are borrowing heavily for expansion, likely to be companies in growth mode.
So the big question is: What will become of technology and other high-flying stocks? Nearly all investment gurus say that the rising interest rate climate makes it time to look elsewhere. Chris Callies, chief equity strategist at CS First Boston, says the cliché of diversification is "really apropos right now."
The Fed has been increasing rates steadily rather than suddenly, like it did in 1987 or 1973, she explained. That steady pace tends to produce rotational dips in value in different kinds of expensive stocks, rather than bringing them all down at once. That's one motive for expanding your investment horizons.
Another is that many investors are heavily or exclusively invested in technology. And technology companies are particularly at risk as the Fed steams ahead with higher rates.
Not only are they highly priced with high price-earnings ratios, but they also are more susceptible operationally, with shorter track records, less-diversified lines of business and less-experienced management.
The economy does need cooling to douse the looming whiffs of inflation, Callies said. And as interest rate increases filter through, "someone's top line, someone's sales, are going to wobble a little bit." Relatively new companies with untested executives -- technology companies -- will stumble the hardest.
Tech stocks are counting on volume increases in the days and years ahead. That growth may not be as good as expected, which means very bad news for their stockholders. "When they miss, they miss big," Callies said. "The risk of these returns is fairly high, or higher than more-established stocks."
Earnings will be the driver; investors should shop around
John Manley, senior equity strategist at Salomon Smith Barney, thinks stocks will not suffer heavily as long provided their earnings remain strong.
For instance, good numbers boosted financial stocks, normally interest-rate sensitive and the first to stumble when rates go up. But they had good run-ups in the few days ahead of the Fed's announcement. That's because their earnings were good and they proved they'd diversified their revenue away from interest-rate-based products into fee-based services and the like.
In fact, financials and pharmaceuticals have become flavor-of-the-month sectors. Both are growth sectors that haven't shared in the booming stock prices that technology and telecommunications have seen.
Manley thinks tech stocks will finally feel the effects of the Fed's moves, but that the effects won't come right away. "Even though they'll be the ultimate victim, they won't be the immediate victim," he said. Portfolio managers will have to hold them, fearing they won't be able to get good growth anywhere else. If the Fed persists in cooling the economy, though, "tech stocks will suffer."
Consumer cyclical stocks, some transportation stocks and some pure cyclical stocks will feel the pinch first, Manley said. But he agreed with Steinberg that the second half of 2000 will likely look a lot better than this period when the Fed is actively moving to slow the economy. "I don't think it's a negative market. I think the risk is fairly limited. But we need to fix a few things," he said.
What do interest-rate hikes mean to investors and the mythical man on the street? It depends heavily on whom you ask. Financial planners, who mainly recommend that investors stick with their holdings long term and weather any storm, have very different reactions from equity strategists, who pick sectors they think the current circumstances will favor.
But if Callies' evaluation is correct -- that slow interest rate increases cause setbacks in different sectors that rotate, tech stocks' growth may slacken, and the markets will bounce erratically in the foreseeable future - then diversification is a regular investor's best friend.
Get a good asset allocation plan and make sure you stick with it
The effects of frequent interest-rate hikes may force you to reposition your portfolio. You should already be considering rebalancing if you're too heavily in techs after their run-up last year, and that's doubly true given the risk they'll be hurt by the rate increases.
But in general, interest rate increases aren't much to worry about if you've got an asset allocation strategy and you're sticking with your long-term plan, financial planners say.
"What matters is, number one, establishing a goal, number two, establishing a strategy that helps you reach those goals, and, number three, not changing that strategy based on the noise going on in the market, which is best left to the short-term trader," said Roy Diliberto, president of the Financial Planning Association.
Two factors cause investors to miss their goals, he said: fear and greed. Paying too much attention to the effect of an interest-rate hike plays into both. "Beating the market is not a goal in my mind. Having enough money to retire and not running out of money, perhaps leaving a legacy or funding some charities; that is," Diliberto said.
As interest rates rise, you will likely want to hold some bonds. Diliberto suggests buying longer-term bonds so you lock in the higher rates available as interest rates rise. If bonds rise to very high yields, it's possible you might need to shift your asset allocation in favor of them. But very high interest rates and yields normally mean high inflation, and inflation isn't good for bonds, Diliberto said.
For households, borrowing gets more expensive
The most immediate effect of an interest-rate hike on consumers is that borrowing gets more expensive. The most immediate effects from a rate increase hit the housing market. With mortgage rates hitting three-year highs, this is not the time to think about shopping for a better mortgage. And indeed, mortgage refinancing has largely disappeared.
On the average $100,000 30-year fixed-rate mortgage, a quarter point increase means $20 extra a month, according to Dave Littmann, chief economist at Comerica Inc. That's $6,500 over the course of the loan. Multiply that by three and we're talking real money, and we haven't even considered compounding the interest.
Adjustable-rate mortgages start looking a lot more attractive to potential homebuyers as a result. "The problem is, they're variable," said Steve Rhode, president of Debt Counselors of America. You can be hurt if rates continue to rise. If the current variable interest rate rises a half point, that adds $50 a month on the median $130,000 home loan and a one-year variable rate mortgage.
It's also not the time to be taking out a home-equity loan on your house. Many people take out loans to pay down credit-card debt. But higher interest rates mean this is not the time to borrow at all. "I wouldn't panic just because interest rates go up a quarter point," Rhode said, but expect every loan you have to get a little more expensive. Faced with that, "You should review your finances and see if there are areas I can cut back, areas I don't use," Rhode said. Do you need those premium cable channels? Do you need all those expensive phone features?
Credit-card rates will also increase as a result of each rate hike, though negligibly because they're already so high, at 19 percent or so. At those levels, Littmann says the payment on $1,800, the average balance people carrying credit-card debt have, goes up 50 cents.
The effects are less noticeable on the smaller sums of money people are likely to borrow. Three rate increases last year did next to nothing to dent car sales, which posted great numbers for January despite cold weather and the Fed's attempts to cool the economy. But that's not that surprising. Littmann figures the average car loan ran 7 percent before this increase, a discount to the 9.5 percent bank rate. A quarter point boosts payments by $3 a month or $120 over the course of a four-year loan. Even three rate increases only build in $360, less than many drivers spend on their stereos. And if you gotta drive, you gotta drive.
The roller coaster isn't a ride most of us need to take
The key point consumers should make of the rate increase today, and the threat of future boosts, is that you should try to lower your debt and make sure your investments are widely diversified. Because the U.S. market is likely to waver while the Fed keeps to its course, international markets may hold a good opportunity, financial adviser Ric Edelman said.
But international stocks would also be built into a good asset allocation plan. If you've got that, you're sitting pretty. "If you're portfolio consists of nothing but tech stocks, you should seriously consider repositioning," Edelman said. Value stocks may look good again, and he thinks the dot.com mania is nearing an end.
So spread your wealth, and you should be fine. If you do, you can rest easy while the market shudders. "Interest rates are cyclical; they go up and they go down," Edelman said. " Trying to ride that roller coaster is silly."