Interest rates, after nearly eight years of generational lows, look to be on the rise in 2016. To understand how the year could play out, let's dive into why we have the low interest rates we do today, why the Fed would raise rates now, and how a change could impact your finances.
Current rates are low for a very good reason
Lowering interest rates is one of the Federal Reserve's primary tools to stoke economic activity. Lower rates encourage business activity and consumer spending. They also make houses more affordable, as we saw in the wake of the financial crisis.
For businesses, lower rates make borrowing cheaper. That, in turn, gives the business an incentive to invest in innovation and new facilities in order to boost productivity down the road. In a higher-rate environment, achieving a suitable return on investment in these initiatives can be difficult thanks to steeper borrowing costs.
For consumers, lower interest rates make saving less attractive, because the rates available for CDs, money market accounts, and savings accounts don't generate high enough returns. Consumers tend to respond to this by spending cash instead of saving it. That spending could be by investing in the stock market, completing home-improvement projects, or simply going out to eat more.
For the real estate market, lower interest rates reduce the cost of purchasing a home. A $200,000 mortgage with a 7% interest rate and 30-year term has a monthly payment of $1,331 per month. Lower that rate to 4%, and the monthly payment drops to $955. That's a 28% savings, and a strong financial incentive for prospective buyers to enter the market.
What will rates look like in 2016?
It's impossible to say exactly where interest rates will go in 2016, but most experts anticipate any rate change will happen slowly so as not to unduly disrupt the markets or the economy. In the minutes of the Fed's October meeting, chairperson Janet Yellen addressed the pace of change, saying that "a gradual increase in the target range for the federal-funds rate will likely be appropriate."
What specific numbers should you expect? Again, this is just an educated guess, but Wells Fargo's Economic Group predicts that the fixed-rate 30-year mortgage rate will rise to just 4.2% by the end of 2016. Their predictions see a larger jump in short-term rates, with LIBOR increasing from around 0.35% to 1.45%, the Prime Rate from 3.25% to 4.25%, and the Fed Funds rate jumping from 0.25% to 1.25%.
Will rising rates be a bad thing for the U.S.?
Ending the low-interest-rate stimulus may seem like a bad idea after considering how it stokes the economic fire. That isn't necessarily true.
First, keeping interest rates too low for too long can cause high inflation. So far in this economic cycle, that has not happened, but it's a serious concern for the economy. High inflation is one of the most-dangerous economic scenarios, as your buying power decreases rapidly, effectively lowering your standard of living with every passing day.
Second, cheap money can also encourage businesses and individuals to take on too-much debt, a cycle that ultimately leads to bubbles and crashes. Many economists point to the extended period of low rates in the early 2000s as a root cause of the financial crisis and real estate collapse in 2008-2009.
Lastly, and most encouraging, the Fed's decision to raise interest rates now indicates that the U.S. economy is strong enough to grow without the need for extra monetary stimulus. GDP growth has been improving this year, and the employment market is in the best shape we've seen since before the recession.
Viewing the landscape from this high-level vantage point, the decision to raise rates is an indication that the U.S. economy is healthy and doing well, even if that means loans will be more expensive.
For investors, what's the best play?
For investors, rising rates may be a catalyst for a few interesting opportunities in certain stocks. For a more extensive discussion of which stocks I think are best positioned for a 2016 interest-rate change, click here. In short, I think that 2016 could be a big year for bank stocks.
Banks will benefit from higher interest rates thanks to increasing net interest margins. Net interest margins essentially measure the difference between what a bank pays out in interest expense versus what it receives in interest income from loans. As rates rise, banks will be able to raise loan prices faster than deposit account yields, effectively increasing their profit margin without changing anything else about their operations.
Consider Bank of America. In its quarterly reports, the bank estimates that, if rates increase by 1% during the next year, its annual profits should rise by $3.85 billion. During the 12 months from the 2014 fourth quarter through the 2015 third quarter, Bank of America reported $16.3 billion in net income. A $3.85 billion increase, thanks to a rate hike, works out to a 24% increase, holding all else equal.
In the same way, JPMorgan Chase could increase its profits by upwards of $2.7 billion with a 1% rate hike during the next year. Based on the trailing four quarters total net income of $23.9 billion, that increase would translate into an 11.3% gain for JPMorgan Chase.
What will happen? We'll all have to wait and see
Whether you're planning your 2016 spending budget, considering taking out a mortgage, or researching the implications of a rate change on stocks, 2016 is shaping up to be quite a year. As the year progresses, the Fed, the market, and individuals will have a front row seat to see how stocks, mortgage rates, and the economy react. In any case, it's going to be an interesting ride.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short January 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.