What's Up With Interest Rates (Puns Are Fun)

Today the FED decided to raise interest rates. Rates have been kept in check since December, 2008, hovering between 0% and 0.25%. Chairwomen Janet Yellen and the Federal Open Market Committee finally decided there was enough strength in the economy to support a rate hike.

What we don't know is to what extent various entities will be impacted, as well as the effect on the markets. I have some insights.

First, let's look at what rate we're actually talking about. When anyone in the media talks about interest rates they're referring to the Federal Funds rate. This is the percentage amount that banks lend with, mostly to other banks. You've probably heard that banks need to have a certain amount of money in reserve. It's not the brown bags with dollar signs they keep in the vault. Based on the banks creditworthiness, most banks have funds on "reserve" at the Federal Reserve.

The Fed Funds rate is a little different than the interest rate tied to Treasuries. Treasury Bills and Notes are short / intermediate term government bonds used to finance the debt of the nation.

Government bond investors might not have noticed the yield (rate) on the 2 year treasury note has doubled from 0.45% to 0.90%*. The 1 year treasury note has moved from 0.15% to over 0.50%. Get this, the 6 month treasury bill hopped from 0.03% in May to over 0.30%**. Exciting. I know...

Those numbers are just what has happened this year. Looking back a bit we can see a steady rise.

Chart Source: Barclays Bank PLC

Talk of interest rate hikes tends to freak people out. We're told that when rates rise, bond prices decline. While that's true, it's relative. For example, most short and intermediate bonds don't react as violently as many believe. Despite all the incremental rate hikes since 2013, we haven't seen the predicted storm in the credit markets. As evidence, the Vanguard Short Term Government Bond ETF has returned 0.32%, 0.46%, and 0.57% in 2013, 2014, and YTD, respectively.

In a Previous Blog Post, I show the historical returns of intermediate & long term treasuries during periods of rate increases. You might be surprised to see how well, on average, treasuries have done during those periods. If you're still freaking out, quit...

When the Fed Funds rate changes, it affects almost everything according to the Wall Street Journal; banks, corporate bonds, the dollar, emerging markets, the Euro, gold, high quality stocks, the housing market, life insurers, money market funds, oil, ok that's probably enough.

Some of these entities will see a positive impact, like banks- who get to charge more interest. Some see a negative impact- like higher dividend stocks, that now have to compete more with bonds for investor income.

Your stocks should be relatively unaffected by today's small 0.25% increase. Historically, stocks have returned 9.9% during rate increases***. Of course, the last two rate hikes directly preceded the tech bubble and the Great Recession, sooooo.... we'll just have see what happens.

* As of November 18th, begining January, 2015.

** As of today.

*** Since 1983, When the Federal Reserve hikes interest rates, stocks and other assets do surprisingly well, Wall Street Journal, Dec. 16th, 2015.