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What Higher Interest Rates Could Mean for You

Karin Kimbrough, our head of Investment Strategy, answers your questions

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THE MARKETS ARE SENSITIVE—they tend to react to sudden change or uncertainty with volatility. But that doesn’t mean you have to react every time there’s up or down movement in the Dow or S&P 500. It’s generally best to keep your overall strategy tied to your personal goals and situation—including your time horizon and the degree of risk you’re comfortable taking on.

That said, the Federal Reserve’s (Fed’s) recent interest rate increases do mark an important shift in economic policy, with the potential to affect the markets in both the short and long term. Uncertainty around when and how often the Fed might continue to raise rates is a consideration you’ll want to factor into your investment decisions this year. We asked Karin Kimbrough, head of Investment Strategy, Merrill Lynch Wealth Management, to explain what these recent actions may mean to investors like you.

Why has the Federal Reserve begun raising interest rates?
The short answer is the Fed is increasing rates because it’s seen so much improvement in the U.S. economy, and it wants to prolong that health.

“Back in 2008, the Federal Reserve slashed interest rates to near zero to help the economy climb out of the Great Recession. Economists believe that move played a key role in supporting the economic recovery that followed.”— Karin Kimbrough, head of Investment Strategy, Merrill Lynch Wealth Management

Many economists believe that low rates—which can help a weak economy grow faster--sometimes lead to problems, including inflation and imbalances in the financial markets. When the Fed is concerned about issues like these, it typically raises the Federal funds rate1, effectively tapping the economy’s brakes. Interest rate changes take time to affect the economy, so the Fed makes its decisions based on its projections for the coming year.

Give us a little history lesson. When did the current period of low rates begin?
Back in 2008, the Federal Reserve slashed interest rates to near zero to help the economy climb out of the Great Recession. Economists believe that move played a key role in supporting the economic recovery that followed. When Federal Reserve policymakers met in December 2015, they saw an economy and job market that looked healthy and likely to keep improving, in part because consumers’ finances were stronger than they had been in years. So they initiated a small rate increase.

Annual inflation remained below the Fed’s target of 2% over the following year. So when Fed economists in December 2016 looked at the next six to 12 months, they became concerned that keeping rates this low could worsen some imbalances in the markets, potentially causing the economic recovery to burn out. So they raised the target range for the federal funds rate again, to try to keep the economy growing at a moderate, sustainable pace.

Federal Reserve Chair Janet Yellen has said that the Fed expects to make further, gradual interest rate increases throughout 2017 and 2018.

How might interest rate increases affect my investments?
You can expect the value of your investments to fluctuate more than it has over the past few years as markets adjust to higher rates, as well as the unknowns surrounding how new trade policies and tax reform plans might play out.

“For long-term investors — like virtually everyone saving for retirement or other future goals — rising interest rates may actually be good news.”— Karin Kimbrough, head of Investment Strategy, Merrill Lynch Wealth Management

Some investors are especially concerned about the impact the Fed’s rate increase may have on their bond mutual funds or exchange-traded funds (ETFs), because rising interest rates push down bonds’ values in the near term. This concern is understandable, and in fact some bond funds may experience short-term declines. But the Fed has said repeatedly that future rate increases are likely to be small and gradual, which may minimize the impact on bond funds. Moreover, for long-term investors — like virtually everyone saving for retirement or other future goals — rising interest rates may actually be good news. The reason: Over time, higher rates make it possible for bond funds to pay more interest.2

Should I make any changes to my investments in anticipation of likely rate increases?
Regardless of what happens over the coming months, focus on investing for your time frame, which may extend over several decades. If that’s the case, the impact of short-term market turbulence is likely to be negligible by the time you need to draw upon your investments. If, however, you’re nearing your retirement and the markets decline significantly, you might consider reducing the amount you plan to withdraw in your first few retired years to give your investments a better chance to recover.

When it comes to your fixed income investments, it’s worth saying again that they’re essential to a diversified investment strategy. Bonds can generate yield and provide a source of income — and therefore returns — regardless of whatever might be happening in the markets.

As for which types of bonds to consider, high quality corporate bonds, due to their yield advantage over treasuries, may be a good opportunity. We also like municipal bonds, where appropriate, as they can often offer tax advantages. In addition, we suggest investors consider a barbell strategy. This combines bonds with short- and long-term maturities (as opposed to intermediate-term), an approach that can help reduce risk while offering the potential for higher returns.

How might the Fed’s move affect my finances outside my investments?
The new Fed policy may result in you earning slightly higher interest on any cash savings you might have, such as bank savings accounts, money market accounts or certificates of deposit (CDs). Likewise, interest rates may rise a bit on debts such as credit card balances, auto loans and mortgages. Increases are projected to be relatively small, however, given the current low level of interest rates and the Fed’s stated intention to move slowly with future rate hikes.

What is likely to happen with interest rates going forward?
The Federal Reserve will be watching to see how this year’s increases affect the economy. If the job market and other financial indicators remain strong, the Fed is likely to follow through on its plan for continued small interest rate increases.

Along the way, you may see or read news reports on small changes in the economy, including predictions about the Fed’s actions and what they mean for the financial markets. Those stories might be interesting and educational, but they shouldn’t influence what you do with your long-term investments. Your job is to tune out that noise, and to maintain a portfolio that gives you the opportunity to achieve your long-term goals.

3 Questions to Ask Your Advisor

  1. With interest rates likely to rise, should I be thinking about bonds in a different way?
  2. Are there sectors that could be affected more strongly—or less so—by rising rates? How might that affect my investment decisions?
  3. Could rate hikes affect my ability to secure credit?

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The federal funds rate is the interest rate charged by commercial banks to other banks who are borrowing money, usually overnight.

Important Note on Bond Funds: Return of principal is not guaranteed. Bond funds have the same interest rate, inflation and credit risks that are associated with the underlying bonds owned by the fund. Generally, the value of bond funds rises when prevailing interest rates fall and falls when interest rates rise. There are ongoing fees and expenses associated with owning shares of bond funds.

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