Stock Market: The Impact of Higher Interest Rates

On Dec. 16, the Federal Open Market Committee of the Federal Reserve Board announced that it was raising the target range for the federal funds rate from 1/4 percent to 1/2 percent. Moving forward, the Committee will analyze economic conditions and how they align with the Fed’s objectives for maximum employment and 2 percent inflation. As of now, the committee expects to make further gradual increases in the federal funds rate.

The federal funds rate is the central interest rate in the U.S. financial system. While the Federal Reserve adjusts the rate via government bond purchases with the intent of influencing lending rates down the line, the actual rate is determined by trading between banks.

Higher short-term interest rates are positive for interest deposits on CDs, money market and bank savings accounts. On the flip side, higher rates also increase the interest rate banks charge on car loans, credit cards and mortgages. As for the financial markets, investors have anxiously anticipated the increase for more than a year, so they were well prepared for the move that resulted in little market interruption or reaction when announced.

Many of today’s stock prices are perceived to be expensive, but higher interest rates indicate that economic growth in this country is on firm ground, which benefits companies on the stock market. Obviously, stocks of banks and financial companies that lend money will benefit, including online brokers, asset managers, trust banks, consumer finance and diversified banks. Shareholders in these companies are poised to benefit as well.

On the other hand, companies that rely on borrowing to meet capital expenses might experience lower cash flow and reserves, since higher rates mean higher borrowing costs. The bond market also is vulnerable to even modest increases in Fed interest rates. In fact, junk bonds could suffer significantly if more expensive borrowing tips those companies in a weak financial position into filing for bankruptcy.

Globally, the Bank of England generally follows the Federal Reserve’s lead and is believed to be next in line to raise interest rates in mid-2016 if not earlier. Though slightly behind the U.S, the U.K.’s economy has recovered well and has produced a strong labor market.

Because the value of the U.S. dollar strengthens with higher interest rates, the impact is likely to dampen the values of emerging market currencies. Higher U.S. rates will accelerate capital outflows from China, while lending to China by foreign banks is likely to be reduced. If China – acknowledged by many as the world’s second economic superpower – becomes more unstable, it might need to sell off more of its holdings in U.S. Treasuries. As the largest foreign investor, this could create funding shortfalls for the U.S. government and add further upward pressure on domestic interest rates.

Other emerging market economies that depend on commodity exports and short-term capital flows to finance current account deficits could also suffer from rising U.S. interest rates. These countries include Brazil, Russia and South Africa.

The comments above are general in nature and are not intended to replace specific advice from your expert tax and investment advisors.