The Federal Fund Rate and Your Wallet
Cash management and portfolio decision-making at a time of skyrocketing rates
The Federal Reserve recently raised its benchmark interest rate by 0.75 percentage point in an attempt to combat persistent high inflation. The benchmark rate now stands between 1.50% and 1.75%. The Fed has publicly indicated that additional rate hikes are possible with some analysts projecting that the federal funds rate may rise as high as 2-3% by year’s end.
This is noteworthy for the average investor because the federal funds rate impacts quite literally everything in the world of finance. Like a pebble tossed into the pond of the national economy, the ripples are felt across the lending landscape. The federal funds rate is the base rate at which lending institutions borrow from the federal reserve and affect the interest rate charged on loans and the yield paid on cash deposits. This prompts a corresponding rate rise on virtually all financial instruments.
Cash equivalent instruments like CDs and money market funds have seen a dramatic increase in rates, with a one-year CD yielding near 3.00%. These cash equivalents are now more attractive to investors because the higher returns help to partially offset some of the impact of recent inflation. However, it also might make sense to invest some of that cash in reliable stocks at a time when the market is at a low ebb. That decision-making involves some thought and consideration, however, as rising rates might make putting money in growth stocks (a strategy that has been very popular in recent years) less attractive, given that higher rates could potentially inhibit that growth. That is almost certainly why recently we’ve seen growth stocks underperform value stocks. This kind of modest, broad-based de-risking is a natural reaction both to these recent rate trends and to the expected continuation of those trends in the months ahead. There are certainly some investors right now who find themselves less likely to buy certain stocks and who might be perfectly comfortable with 3% returns on a CD or yield slightly above 4% on a corporate bond held to maturity.
Speaking of bonds, dramatic increases in treasury rates (we have recently seen the 10-year treasury rate move above 3%) impacts not just lending, but bond yields. The bond market has shifted significantly in recent months, with yields on bonds in the open market substantially higher than they were a year ago. Depending on your circumstances, that could be good news or not-so-good news. People looking to acquire bonds now can get them at higher yields, but those looking to sell bonds they’ve been holding may face losses. However, holding a bond to maturity can potentially enable you to recover that loss.
Of course, the federal funds rate affects big purchases, too. With lending rates for those looking to buy a house or a car, it could fundamentally change your decision-making calculus about when and if to pull the trigger on those big-ticket items.
The bottom line is that the ripples from the federal fund rate pebble affects everyone differently. Investors should be cautious about overreacting to dramatic headlines. While it might make some sense to move to less risky asset classes with steadier, if more modest, rates of return, that doesn’t necessarily mean a massive portfolio shift—but perhaps more of a subtle shift in strategy. Be leery of definitive statements and one-size-fits-all advice. As always, be sure to talk to a trusted financial advisor or wealth management professional to determine what cash management strategies make sense for you and your portfolio as the federal funds rate continues to change.