Higher interest rates typically strengthen the U.S. dollar versus other currencies. That tends to make commodities that are dollar-denominated (e.g., crude oil and most global commodities) more expensive to foreign purchasers. “Dollar-denominated” means these commodities are priced in U.S. dollars — so when the dollar rises, it takes fewer U.S. dollars to buy the commodity, but likely more of a foreign currency. Now that may sound like a good thing — or a bad thing. Both are true, depending on how you look at it. A stronger dollar tends to help you at the pump, but weakness in oil prices to some degree tends to limit the stock market’s upside potential.
Rising interest rates make the U.S. look more favorable as a place to buy new bonds in the world market. The U.S. central bank already boasts a higher rate than most other developed markets (i.e., Great Britain: .25%, Europe: 0%, Japan: 0%), and as rates rise, investors can get paid a little more to choose high-quality U.S. bonds over other alternatives. Of course, if you are a business, you’ll be less and less willing to take out a loan to fund expansion as rates rise. If you are a buyer of U.S. bonds, you may see this as good news.
Raising rates signal to the world that we have faith in our economy. It is well known that the dark side of rising rates is that it makes borrowing more expensive, which can slow business growth/risk-taking as well as slow down real estate markets. So, raising rates are a signal that we believe we are strong enough to fight those headwinds and stay on a course for growth. Still, we have to remember that economies don’t typically move quickly and no one thing is the key. Though investors get nervous about rising interest rates, stocks historically tend to perform pretty well after rates start rising.
Borrows may hasten their decision to take out a mortgage to avoid higher rates. That can mean a temporary boost to real estate, but eventually may be followed by a slowdown, since the people who rushed to market will already be in a home, and a few more will be incrementally priced out of a purchase with each rise in rates. It is important to note that a rise in short-term interest rates does not guarantee a rise in mortgages — which are closely tied to the 10-year note. However, homebuyers associate rising rates with higher mortgages, and that may be enough to drive behavior.
U.S. products become more expensive. Another effect of the strong dollar is that U.S. products become more expensive to foreign buyers. This hurts U.S. manufacturing, which can negatively affect U.S. businesses and their employees. In fact, all products become more expensive to U.S. consumers who buy them on credit, as the interest on credit card payments and auto loans may also rise. Someone who is carrying a credit card balance for an item they previously bought will see the interest they are paying for it go up, which may affect their willingness to buy more goods. While that is a healthy conclusion for the individual, it means slower demand, especially for consumer goods. That may eventually put a damper on stock prices, but if it results in more consumers getting a hold on their personal finances, the long-term benefits may outweigh the short-term slowdown.
In summary, a lot of the effects of rising interest rates are psychological — for businesses and consumers — but those effects carry over into real life. Rising interest rates signal many individuals and businesses to cut back on their spending, though consumers will weigh that against potential changes in any Trump tax plan. Businesses need to spend as an investment so they can boost future returns, so when they spend less, and consumers spend less at businesses, the feedback loop can eventually lead to falling earnings and stock prices. Again, the effects take months and even a couple of years to be fully felt.
While it is true that rising rates may have a significant effect on investment planning, it probably has an even greater effect on the financial decisions individuals make in their daily lives. Though my mind is primarily focused on investing in my role as Chief Investment Officer, our team of Certified Financial Planners™ (CFP® professionals) are always concerned with getting granular with our clients to make sure they are making the best decisions for their individual needs. If you aren’t sure how to communicate with your advisor, here are the Top 10 Things You Should Say to your Advisor.
Other articles filed under Fort Worth CFP Team Posts
Part 2: Volatile Markets – How the Financial Media Helped Build Demand for Dangerous Products Based on the VIX
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