The Federal Reserve and other key central banks have begun a rate-hike cycle. Here's what it means for you as a consumer and as a borrower, as well as what higher interest rates mean for bank profits (hint: it's good) and for dividend investors (not so good).
A full transcript follows the video.
This video was recorded on Nov. 6, 2017.
Michael Douglass: Let's take a step back and talk about, in general, a rising interest rate environment and what that means. Let's face it, U.S. interest rates are definitely increasing, and they'll actually be increasing, as you noted, probably a good bit faster than the U.K.'s. I think the first group we should talk about are consumers. If you are a consumer, a rising interest rate environment primarily affects you because, when you borrow money, you're going to be paying more interest. On the flip side, you're going to get a little more interest when you open a savings account or a CD. So, when you deposit money in the bank, maybe instead of, I'm making this up here, 0.01%, you might be getting 0.5%, or even one day 1% or 2%. That's not historically unreasonable to see, at some point in the relatively distant future. So, that should help some of those yields for consumers.
Matt Frankel: Definitely. It's also worth pointing out that some things are directly related to rising benchmark interest rates while some aren't. You mentioned savings accounts. So far, savings accounts really haven't risen proportionally to the [benchmark] interest rates.
Douglass: Not at all! [laughs]
Frankel: Not at all. But some things have. Credit cards will rise immediately after the rates are increased. Any kind of loan that's tied to a benchmark, like an adjustable rate mortgage, for example, would rise immediately. Whereas things like non-adjustable mortgage rates, savings, CD rates, they tend to move with rate hikes, but it's not a perfect correlation.
Douglass: I think that's a great point to make. The other thing to consider is, one of the other groups that's said to be affected by interest hikes are banks themselves. Banks make their money by taking in money, usually through checking accounts, savings accounts, money markets, things like that, and then loaning it out at a higher rate. So, as rates go up, they can theoretically put that money out at an even higher rate, and that will juice their returns. So, banks in general should benefit substantially from interest rate increases.
Frankel: That's especially true that, when rates rise faster than rates on deposits are rising, like we just mentioned with the savings accounts, generally the effect is, when rates rise, borrowing rates tend to rise a little bit faster than deposit rates, which is what's called margin expansion for banks. So, banks tend to make a higher percentage as they're loaning money out for a higher rate, and not paying quite as much more on deposits. So, that's why in the past quarter, you've seen pretty much every bank other than Wells Fargo (NYSE:WFC) make higher interest margins by about 10 to 12 basis points. So, you'll see this as interest rates continue to rise, a little bit more margin expansion, which is very good for banks.
Douglass: Absolutely. Then, for investors, one of the interesting things about rising interest rates is, usually it'll drive down bond prices, which will then improve bond yields. If you have -- I'm making this up -- a $10 bond that yields $1 per year, that would be a 10% yield. That would be insane, by the way, much higher than we get right now. But if the price of that bond drops to $5, then suddenly that $1 yield becomes a 20% yield, even though it hasn't changed any, it's just that with the price lower, that yield is then better. What's interesting about this to me is that if bond yields improve substantially -- right now, you see a lot of bonds paying 3% to 4%, if that starts getting up into 5%, 6%, maybe even 7%, I think a lot of your income investors, these are folks who are at or near retirement, who have been in dividend stocks because they're paying a similar yield to these bonds and you get some potential capital appreciation out of it, might head over to bonds instead of income stocks, which could have some really interesting effects on the dividend stock market. Most of them, let's say not terribly positive for those who are already invested there. Of course, we can't predict the future, but that's just one possible outcome here.
Frankel: Right. A good example I always use, I invest a lot in real estate stocks, REITs, which pay, generally, 4% to 6%.
Douglass: Yeah, they do pretty well.
Frankel: Right, they're some of the highest dividend stocks on the market. And one of the examples I always use is, say, if a 10-year Treasury is paying 3%, and a pretty solid REIT is paying 5%, it's worth taking the extra risk to get that extra yield. However, if the Treasury is now paying 6%, but you can only get 5% from a riskier asset, you lose the incentive to take that extra risk. That can create selling pressure on the stock to jump the yield up, as you were just describing.
Douglass: Of course, on the flip side, when great businesses go on sale, that's a great time to potentially buy in. We've talked a fair amount about dividend stocks and Dividend Aristocrats, and some of these other companies that have really shown their ability to raise their dividends and really reward investors long-term. So, this might create some really great buying opportunities. I know, me personally, I'm looking forward to and hoping for that outcome so that I can pick up some great companies on sale.
Frankel: Me too. It can be painful in the short term to watch the dollar value of your portfolio go down, but in the long term, it's actually a really good thing for people who still have time.
Douglass: Right. So long as it doesn't go down for forever, right? [laughs]
Frankel: Right. Short term, it's OK.
Matthew Frankel has no position in any of the stocks mentioned. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.