When you’re part of the elite group holding the reins of the largest economy in the world, every public statement, and even every word you utter, can potentially rock stock markets, kill jobs, and shutter businesses across the globe. That’s why if you’re speaking for the Federal Reserve, you mince your words as such:
“The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate… Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.”
The language from the minutes of the latest meeting of the Federal Reserve may sound dry or even cryptic to many, but it’s as close to a hint as it gets that interest rates could start going up as early as this year. And the resulting ripple effects will impact borrowers, investors, and financial institutions in very different ways.
Granted, some analysts will argue that a global economic slowdown will delay any rate hikes. But with the US unemployment rate recently falling to 5.6% (well within the Fed’s 5%-6% “normal unemployment” range) and with the cheapest gas since 2009 being the only thing keeping inflation below the Fed’s 2% inflation target rate, it’s only a matter of time before rates begin to rise for the first time in nearly a decade.
If the analysts won’t tell you that, the consumers may. According to the Mortgage Bankers Association, refinancing applications jumped 22% for the week ended January 16, after surging 66% the previous week as consumers scrambled to take advantage of the lowest mortgage rates since 2013. Smart consumerism says you don’t wait to refinance unless you think rates will go lower.
So while no one knows exactly when interest rates will rise in earnest, it’s interesting to discuss who the winners and losers will be in the fallout.
One of the winners, at least in the short term, will be commercial banks. With interest rates hovering around 0% since late 2008, banks have suffered from shrinking interest margins (the difference between what the bank collects in loan interest and what the bank pays in deposits) as they’ve kept loan rates down to compete for cash-strapped borrowers.
But when interest rates rise, banks are able to charge higher rates of interest on their loans and delay raising their customer-deposit interest rates for as long as it’s competitive, which should give a boost to bank interest margins and pad their profits in the meantime. Look for banks with large consumer bases, such asJPMorgan Chase, Bank of America, and Goldman Sachs, to benefit the most.
Brokerage Firms and Mutual Fund Companies
While brokers and mutual fund companies won’t directly benefit from interest rate hikes, the underlying conditions will. The Fed raises interest rates to control inflation when the economy picks up steam and people spend more money — which are good factors for stocks. As analyst Bill Greiner of Forbes explains, “We enter 2015 with an economic backdrop of accelerating domestic GDP growth. This growth acceleration, driven by higher growth rates of consumption, should lead to a good year for corporate profit growth. Rising corporate profits normally lead to rising stock prices.”
As stock prices rise and individuals get into the “fear of missing out” mode, you can expect investment activity to jump and money to flood through brokerage firms and into financial institutions offering stock mutual funds, ETFs, and other equity investments.
Adjustable Rate Mortgage Lenders and Investors
While institutions that hold 30-year fixed-rate mortgages are forced to settle for static interest rates while the market rates rise, real estate investment trusts (REITs), banks, and others that carry or originate adjustable-rate mortgage (ARM) loans or securities will be able to adapt and even generate higher levels of interest.
Take Capstead Mortgage Corporation for example, whose $14 billion investment portfolio is made up almost exclusively of short-duration ARM securities (investments in bundled ARM loans). Depending on the term length, these ARM securities tied to existing loans can raise the borrower’s interest rate within a year or a few years after a Fed rate hike, allowing Capstead to generate more interest from borrowers as rates increase.
Mutual Funds and Bond Holders
Yes, mutual funds companies make the loser list as well, but only those that invest in bonds and bond funds. This is because as interest rates rise, fixed-interest bond securities will fall correspondingly in value as investors sell their holdings to find higher interest returns elsewhere. In general, the longer the term on the bonds, the further the value they will fall.
Particularly at risk are companies like the world’s largest bond fund manager, Pacific Investment Management Company (PIMCO). Under Bill Gross, the firm saw its assets under management break $1 trillion for the first time in 2009 as investors fled from the risky stock market and poured billions into bonds and bond funds. But with rising interest rates looming, the company that made it big with bonds is now playing defense and repositioningits funds toward more equity investments. Look for other large bond fund holders to do the same before it’s too late.
Specialized Financers (Retailers)
Car dealers, furniture stores, mattress retailers, electronic outlets, and other companies that offer special financing particularly for cash-strapped and less creditworthy borrowers will face headwinds of their own as interest rates rise. Not only will their own borrowing rates go up, but as interest rates increase, fewer customers will qualify for financing, which will hurt revenues from financing arms.
Take Nissan car dealers, for instance, who have already been stretching their loan terms to entice customers to buy vehicles, in particular more expensive ones. It may come as a surprise to most readers that in today’s low-interest environment one in four new car loans in recent months were between 73 to 84 months long! Rate increases will squeeze more borrowers out of approval or shrink credit limits, which could pinch specialized lender revenue over time.
For the economy and consumers, the results will be mixed. On one hand, rising interest rates will only come if the economy improves, which should help businesses across the board see increased demand and higher revenues. On the other hand, higher interest rates are essentially the Fed’s way of hitting the brakes on growth, resulting in fewer loans being originated as they become more expensive and less spending as deposit accounts become more interesting (no pun intended) to consumers.
While there will be winners and losers in a rising interest rate environment, I would say that interest rate increases will overall be a good thing as they will come with a growing economy. And after six years of near stagnation, that would be a welcome change.