The Federal Reserve met in December and outlined a new course for monetary policy going forward. They signaled two big changes:
- The Fed will stop buying Treasury Bonds and Mortgage-Backed Securities by March
- The Fed expects to raise interest rates 3 times next year, bringing the Fed Funds rate from a target of 0.00% – 0.25% to 0.75% – 1.00%.
The Federal Reserve has a “dual mandate.” The two things they are focused on are keeping the population at full employment and keeping inflation in check. Economists generally view full employment as an unemployment rate of 5% or lower and the Fed targets long-term inflation as 2%.
These moves are expected to be modestly harmful to asset prices and represent action meant to cool an economy that is overheating. There is good reason for this, in November, the unemployment rate dropped to 4.2%. At the same time, the Federal Reserve is expecting inflation of 5.3% for 2021 and real GDP growth of 5.5%.
What does that mean for us?
Higher Short-Term Interest Rates: Remember a few years ago (2018) when you could actually get some return from a high-yield savings account or a 1-year CD? That’s expected to come back. A year from now we should see these paying north of 1%. If the Fed’s longer-term expectations are realized, by the end of 2024 these numbers will be around 2.5%.
Higher Mortgage Rates: With the Fed raising the Fed Funds rate and no longer buying longer-term bonds, markets expect yields to rise most everywhere, including with Mortgages. When the Fed last had multiple rate hikes in a year (2017 – 2018), we saw 30-year mortgage rates go from 4% to 4.9%. Current mortgage rates sit at 3.1%. As these rates rise, expect the housing market to cool as the carrying cost of homes increases.
Lower Returns over the short-term: We’ve been warning our clients of this for several years now, and we may finally be right (unfortunately). As interest rates rise, the value of existing bonds declines. We’ve seen that this year and it could happen again. Rising interest rates affects not only bonds, but stocks too. In calculating the value of a stock, you discount future cash flows from the stock. Higher interest rates mean a higher discount rate which leads to a lower current price for that stock. However, it’s not all bad news. While the price of existing assets goes down, the expected return going forward increases.