After raising interest rates three times since December 2015, the U.S. Federal Reserve says it wants to increase interest rates two more times this year. I believe those rate increases will happen. I also believe they will be devastating to our economy in three ways.
Interest Rates & Housing Market
Activity in the housing market is highly correlated to the direction of interest rates. It’s simple: as the Fed raises its benchmark interest rate (known as the Federal Funds Rate), banks raise their mortgage rates. As the mortgage rates move higher, demand softens in the housing market.
Advertisement
In March 2016, the 30-year fixed mortgage rate was 3.69%. In March 2017, it shot up to 4.2%. (Source: “30-Year Fixed-Rate Mortgages Since 1971,” Freddie Mac, last accessed April 6, 2017.)
Add two more interest rate hikes this year and, all of a sudden, a 30-year fixed mortgage gets very close to 5.0%. This will hit the housing market like a brick wall.
Since early 2012, housing prices—as measured by the S&P/Case-Shiller U.S. National Home Price Index—have risen by 48%. This type of price growth is coming to a quick stop.
Interest Rates & Derivatives Market
The next big risk for higher interest rates is the derivatives market.
At the end of 2016, the top 25 U.S. banks had derivatives with notional value of $164.6 trillion. Of this $164.6 trillion, 75% was tied to interest rates. That’s $123.45 trillion in derivatives tied to interest rates. (Source: “Quarterly Report on Bank Trading and Derivatives Activities” Office of the Comptroller of the Currency, last accessed April 6, 2017.)
To add some perspective, total global gross domestic product (GDP) is about $76.0 trillion. In other words; the top 25 U.S. banks have 1.62 times the value of the total global economy tied to interest rate sensitive derivatives. What happens to these derivatives as interest rates rise? It’s a scary thought.
Interest Rates & Stock Market
Finally, higher interest rates are an enemy of the stock market. Sure, rising interest rates will cost public companies more in interest expense. But the stock buy-back phenomena of the past few years has made higher interest rates especially risky.
Again, providing some perspective: in the third quarter of 2016, 72% of companies on the S&P 500 had bought back their shares. On a trailing 12-month basis, they purchased $556.6 billion worth of their own stocks! (Source: “Buyback Quarterly,” FactSet Research Systems Inc, December 19, 2017.)
If higher interest rates sway companies from borrowing money to buy back their shares, the floor support system that these companies are providing to their stock prices could be taken away very quickly, putting downward pressure on stock prices.
Dear reader; higher interest rates in 2017 are a serious matter. Not enough attention is being given to these higher rates. You should really look at your portfolio and assess how rising interest rates will affect your investments. Then you should prepare by adjusting your positions accordingly.
