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US interest rate rise: Your questions answered

adamlewis
Written By:
adamlewis
Posted:
Updated:
16/12/2015

After almost a decade of perennially low interest rates, the first official US rate rise has now been confirmed.

While the first move upwards since 2006 was largely baked into market expectations, investors remain understandably anxious about what the end of cheap money will mean for financial markets.

Many are nervous about a ‘rate rage’ along the lines of the 2013 ‘taper tantrum’ when the former Fed chair Ben Bernanke announced the withdrawal of US quantitative easing. But this time around the US economy is looking a lot more robust and the central bank has been priming markets for a rate rise for seemingly forever. The Fed’s aim is to avoid taking markets by surprise, and the December hike will certainly not come as a shock.

Here are your most important rate rise questions answered:

Why are US rates finally going up?

In short: the Fed is running out of reasons not to raise rates. The US economic recovery is on track; jobs figures are robust with the country’s unemployment rate dropping to 5.0% in November – the lowest since 2008 and recently wages have picked up. Fedspeak increasingly hinted at a rate rise with comments from Fed chair Janet Yellen pointing to a highly imminent rate hike and the minutes of the last October 2015 Fed meeting showing that ‘most participants’ felt rate rise conditions ‘could well be met by the time of the next meeting’.

How will the rise play out?

Fed vice chair Stanley Fischer said the pace of rate hikes will probably be more akin to a ‘crawl’ than a ‘lift-off’. While US wage growth has ticked up recently, overall inflation is still very low hovering around the zero-mark while growth in the global economy is spluttering. The trajectory of future rate rises matters and the Fed won’t be taking any chances by pushing up rates too quickly – expect a gradual, incremental rise from here.

Where will rates end up?

For long term investors the speed with which rates will rise and where they finally settle matters a lot more than the actual date of the first rate rise. The Fed’s estimates are for a long and steady climb beyond 2018 with only a modest expected tightening of around a percentage point in both 2016 and 2017. Expect rates to settle at much lower averages than previously.

What will it mean for your investments?

There will be volatility as rising rates tend to expose weaknesses in the world economy with riskier areas like emerging markets and low grade bonds likely to be hardest hit.

There is also the possibility that the dollar continues to rise while past experience shows that US equities tend to climb significantly ahead of the first rate rise – the US stock market has ended up materially higher one year after the first rate hike in each of the last four hiking periods. With uncertainty over what a rate rise may bring out of the way, the case for the US equity bull market staying on track appears good. A rate rise will bring less good news for fixed income markets as higher rates translate into higher bond yields and higher borrowing costs.

Will UK interest rates follow suit?

While there is no formal link between US and UK interest rates, historically these have tended to move in tandem with the Bank of England following the Fed’s lead. This time around things look a lot different. At the Bank’s last ‘Super Thursday’ meeting which sees the release of the latest Monetary Policy Committee (MPC) meeting minutes, the quarterly inflation report and the bank declare its hand on interest rates, it looked entirely possible that UK interest rates will not rise at all in 2016.

It’s not just the starting point for the UK rate hike cycle that has been pushed out. The trajectory is also a lot flatter. On the basis of the Bank’s own projections, the only way inflation will be back above the 2% target in two years’ time is if the Old Lady limits herself to two quarter point hikes in 2017. We could very well see UK interest rates at just 1% a decade after the start of the financial crisis.

What happens if UK rates do eventually rise?

As rates rise, they will impact families differently, depending on the size of their borrowings and the terms of their mortgage. Younger households – those in their thirties and forties – have done relatively well from the prolonged period of lower interest rates. But this has also left many overburdened with high levels of mortgage debt. In contrast, the older generation of homeowners is in a much better position, having benefited from a steady rise in house prices.

What does a rate rise mean for retirees?

Annuity rates which have been at historical lows could improve with a rise in interest rates, which means those planning to retire soon could secure a higher income.

Less positive is the possibility that retirees could see a fall in the value of their pension funds. This is because when investors near retirement age, pensions savings are often automatically moved out of the market and into bonds, as a way of de-risking pension savings – a process known as ‘life-styling’. Bond prices tend to fall when interest rates rise, in order to increase the yield and attract buyers.

And if UK rates stay lower for longer?

Low rates and stagnant wage growth mean investors need their investments to work even harder to generate a decent level of income.

We calculate that if a saver had invested £15,000 into the FTSE All Share index over the 10 year period from 31 October 2005 to 31 October 2015, they would now be left with £27,865.02*. If, however, you had invested £15,000 into the average UK savings account over the same period, you would be left with £16,137.34*. That’s a significant difference of £11,727.68 – too high for any sensible saver to ignore.

Maike Currie is associate investment director for personal investing at Fidelity International

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