The 4 Most Important Effects of Rising Interest Rates

The Federal Open Market Committee (FOMC), the Federal Reserve's interest-rate setting panel, voted unanimously on Wednesday to raise the federal funds rate by 0.25 percentage points to a target range of 0.5% to 0.75%. Stocks hardly budged as a result: the hike was modest, after all, and so thoroughly expected that fed funds futures were pricing in a 90-plus percent probability going into the decision. It's easy to come away with the impression that investors, savers and consumers should carry on as before.

On the other hand, there are good reasons not to be nonchalant. The FOMC signaled three rate hikes in each of the next three years on Wednesday, a faster pace of tightening than it had projected in December, meaning that the target range could be as high as 2.75%-3.00% at the end of 2019. Given that it was 0.00%-0.25% until December 2015, that's a dramatic increase (of course the Fed chronically overestimates the rate of tightening – going by December 2014 estimates, the rate should be four times higher than it currently is). (See also, Fed Projections: Where Do Rates Go from Here?)

The federal funds rate is the bedrock of the world's financial calculus. Raising it pushes up the price of money, affecting rates on everything from credit cards to corporate bonds. It pushes up the yield on Treasuries, which stands in for the so-called risk-free rate of return on which every lending decision is based. It sucks capital into the U.S., that is, out of everywhere else. The fed funds rate is so powerful that it has the potential to wreak political havoc not just at home, but also oceans away.

All of which means that the list below is far from comprehensive. But it's a start.

1. Borrowing Becomes More Expensive

The Fed's key policy rate only applies to overnight lending between banks out of their reserves held at the Fed. In other words, it doesn't affect consumer or (non-bank) business borrowing directly, but the distinction is academic, because it is so closely linked to rates that do affect these borrowers directly.

The prime rate is one. Within hours of the Fed's move, just about every major bank announced that they would raise their prime rates from 3.50% to 3.75%. This rate affects a slew of variable-rate loans, including most credit cards. Mortgages are generally linked to Treasury yields, but these are also rising due to the rate hike: the 10-year Treasury yield shot up nearly 10 basis points to 2.57% Wednesday and is above 2.62% as of 12:15 p.m. EST Thursday. Libor, another common benchmark that serves as the basis for many student loans, for example, rose to its highest level since May 2009 in response to the rate rise. In short, just about every variable-rate lending rate is likely to move more or less in line with Fed actions. Borrowers who can refinance to lock in low rates should consider doing so.

2. Deposits Yield More … Eventually

Higher borrowing costs also apply to banks, which take loans from savers in the forms of deposits. In other words, the savings account that currently pays out a few bucks a year – if that – will become more generous.

But don't hold your breath. Trading gains, fees and other revenue streams aside, banks profit from the spread between the rates they lend at and the ones they borrow at. In other words, they have little incentive to raise the interest they pay on deposits and cut into their profit margins. Following liftoff in December 2015, deposit rates mostly stayed flat. Between the third quarter of 2015 and the third quarter of 2016, Bank of America Corp.'s (BAC) average rates stayed at 0.08%, according to SEC filings. JPMorgan Chase & Co.'s (JPM) rose by a rounding error, from 0.14% to 0.15%. Wells Fargo & Co.'s (WFC) rose from 0.11% to 0.16%, but that's still less than $2 earned per $1,000 per year. The three banks held almost $3.9 trillion in combined deposits at the end of the third quarter.

At some point deposit rates are likely rise due to competition among banks for customers. But unlike rate changes that make the banks money – like raising the prime rate – it will take longer than a few hours. (See also, How Will Rising Rates Impact the Banking Sector?)

As a result of this lag, banks can expect fatter profit margins, and investors are responding accordingly. Bank of America's stock has risen 2.9% to $23.26 from Tuesday's close to 1:49 p.m. Thursday, while JPMorgan's has risen 1.9% to $86.39. Wells Fargo, perhaps due to the ongoing fracas over the debit cards it opened in customers' names without their knowledge, has seen its shares slip slightly. 


Federal Funds Rate

3. Trouble for Stocks and Bonds

In a webcast on Tuesday, DoubleLine Capital chief investment officer Jeffrey Gundlach linked Fed tightening to rising 10-year Treasury yields, which he said could reach the psychologically important level of 3% in the next year. A sell-off in government debt could accelerate the bear market in bonds, which began to take hold almost immediately after Donald Trump's election victory. (See also, Trump Win Shocks Bond Market With $1 Trillion Loss Globally.)

"We're getting to the point where further rises in Treasuries, certainly above 3%, would start to have a real impact on market liquidity in corporate bonds and junk bonds," Gundlach said. He added that equities and housing could also suffer: "a 10-year Treasury above 3% in my view starts to bring into question some of the aspects of the stock market and of the housing market in particular."

Bond yields move in the opposite direction to their prices; since yields are closely correlated to the federal funds rate, monetary tightening implies a bond rout, particularly when trillions of dollars' worth of government bonds have been bid up to the point that they trade with negative yields. 

The relationship between the federal funds rate and equity prices is less direct. Since higher rates serve to reign in borrowing and spending, they can impact companies' bottom lines, particularly in industries that depend on discretionary – and often debt-fueled – consumer spending. Higher rates also make it more difficult for companies to borrow, meaning that the pace of hiring, capital investment, acquisitions and stock repurchases slows. Finally, the ability to receive a decent return from safer investments such as Treasuries and even – some day – savings accounts makes the stock market a less appealing destination for capital. (See also, How Interest Rates Affect the Stock Market.)

4. The Dollar Strengthens

As higher rates make investing in Treasuries and other safe, dollar-denominated assets more attractive, capital floods out of other countries, particularly risky emerging markets. The result is that the dollar gains against other currencies, which can have profound implications for trade and, in a thoroughly trade-skeptical environment, politics. (See also, How Inflation Expectations and the Dollar Can Both Surge.)

The value of the euro, for example, decreased by nearly 1.9% to $1.0428 between Tuesday and 2:40 p.m. Thursday, leading to predictions that the two currencies would soon reach parity. While a one-to-one exchange rate is an arbitrary level, observers focus on it because of its psychological importance: since the financial crisis, the eurozone has been buffeted by deflation, high unemployment, dormant growth, sovereign debt scares, the prospect of bank failures – which could potentially set off another financial crisis – the fallout from Brexit and a vocal anti-euro contingent in almost every country (ironically, euroskeptics are increasingly allied across borders, increasing their effectiveness). If a euro can't buy a dollar when French and German voters head to the polls next year, François Fillon and Angela Merkel's prospects will look bleaker, and the single currency's future will be in question.

The Fed's hike has driven the dollar up against another key currency, the yuan, by 0.6% over the same period. Behind the European Union and Canada (where the currency has also fallen against the dollar), China is the U.S.'s third-largest trading partner. It has assumed outsized political importance due to Trump's emphasis on the U.S.'s trade deficit with China and his claim – apparently false – that China is holding down the value of the yuan in order increase the attractiveness of its exports. (See also, Billionaire Kyle Bass Anticipates 30% Drop in Chinese Yuan.)

By the same token, the dollar's strength will make American exports more expensive, further squeezing the manufacturing sector that accounts for around 9% of U.S. employment but a significantly larger share of the political conversation. 

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