The Cost of Money Increases with Interest Rate Hikes!
The Cost of Money is going to Rise: That’s What Rate Hikes Do
Interest is the price that the borrower must pay, over and above the principal, to the lender for a set sum of money. Simply put, when interest rates rise the cost of money rises too. This has wide-ranging implications for the domestic economy, and the global economy. Not only will rising interest rates cause the cost of your debt to increase, it also eats into your personal disposable income. For these reasons, rising interest rates are perceived negatively by homeowners and those with variable interest rates on long-term loans. However, investors see the upside of rising interest rates. By taking money that earns a low yield and shifting it to a higher yield investment, more profit stands to be gained. The issue of interest rates is a complex one; the pros and cons result in outcomes that are not always clear-cut or desired.
For those who are buried in debt, interest-rate hikes are bad news. The full effects of a rate hike should be carefully factored in to a household’s monthly budget over the long-term. Depending on whether your home loan is fixed or variable, you may or may not be impacted by rate hikes. Numerous types of loans may be impacted by interest-rate hikes, including certain college loans, bank loans, car loans etc. In a time where interest-rate hikes are prevalent, it is always preferable to negotiate for fixed rates over variable rates. The US is currently experiencing its lowest interest rate in decades, and with nowhere to go but up it pays to keep your finger on the pulse with regard to your debt obligations. With credit cards, interest-rate hikes are bad news. However if you are the type of person who pays off all the outstanding debt on a credit card before the end of the month you will not incur interest-related charges.
The Timing of a Fed Rate Hike
There is also another side to the interest-rate saga. If you have excess capital available and you’re looking to invest your funds in an interest-bearing account, rising interest rates will be to your advantage. Savings accounts, Treasury notes and bonds typically prosper when interest rates rise. But since people with excess funds are in the minority, it’s the have-nots that we have to focus on when it comes to the interest-rate debate. Millennials may not recall the last time the Fed actually increased interest rates – it was back in 2006. At the time, markets were expecting such a move. The key policy rate has remained unchanged for 6 years, and many traders have yet to see a rate hike taking place. The chairman of the US Federal Reserve Bank – Janet Yellen – is likely to announce a rate hike by September, or at the very latest December 2015. The numbers of new jobs created in July came in under expectations at 215,000. The consensus number was 220,000 jobs, and there is now a 75% probability in the futures market that interest rates will be raised by September. Top financial analysts at Banc De Binary are of the opinion that Janet Yellen will raise interest rates in 2015. Of course it is essential that the rate of inflation continues moving towards its 2 percentage point target rate, prior to raising the interest-rate. While the economy seems to be moving along nicely, the inflation rate does not appear to be budging.
It should be remembered that Janet Yellen does not want to procrastinate too much when it comes to raising the interest-rate. She prefers a gradual approach to a sweeping approach, and the markets reflect that very viewpoint. Already, investors have priced in the prospect of a rate hike later on this year. Yellen is waiting to see clear and unambiguous signs of an economic improvement in the US. That the Bank of England has decided not to raise interest rates is an important decision, but one which will not have much bearing on Fed policy decision-making.
In order for inflation targets to be reached, costs need to increase. However, slumping oil prices, improved cost-effectiveness in industry and depressed global demand have kept the inflation rate in check. In fact, some economists have gone so far as saying that deflationary pressures are now imminent. This is one of the reasons why the Eurozone has adopted a massive monetary policy expansion by way of QE policies. The problem with deflation is that it stifles purchasing activity because consumers tend to hold off big ticket purchases such as cars, luxury items and homes in the hopes that prices will decline further. Deflation is a real concern in Japan where the government has been battling falling prices for quite some time.
All Eyes on the Fed
The only time an interest-rate hike will be adopted is when the Fed believes that the US economy has grown enough to sustain a rate hike. If the economy is sputtering, it becomes clear that a rate hike is perhaps not the right decision. With unemployment figures hovering around 5.2%, jobless claims decreasing and manufacturing holding steady, the US economy appears to be on track to withstand the effects of an interest-rate hike. Until such time as the inflation rate shows that it is moving in line with Fed expectations, the likelihood of a rate hike is lukewarm. We could see a scenario developing where a chain reaction follows a US Fed rate hike. The Bank of England may well have stood down in August when it decided against hiking rates, but any upward revision by the Fed will certainly encourage similar actions by central banks around the world.
The Monetary Policy Committee (MPC) of the Bank of England does not wait for the Fed in order to make its own decisions; however there is careful analysis of global monetary policy decisions coming out of the US. The data certainly points towards rising prices, as evidenced by CPI indexes. The consumer price index in the United Kingdom remained unchanged between 2014 and 2015, with inflation over the past several months hovering at 0.0%. In the U.S., the CPI for all urban consumers increased by 0.3% in June, following a 0.4 percentage increase in May. For the 12 months ending June 2015, the US inflation rate is 0.1%. The next inflation rate update will be released on 19 August at 8:30 AM EST for the 12 months ending July 2015.
Once the first interest-rate hike is put in place, more are likely to follow. What is of paramount importance is the pace of rate hikes, not when they begin. Since the Fed is counting on data to determine when it will implement a rate hike, it is more likely that this will come sooner than later. Stronger data will appear in Q3 and Q4 of 2015. If the Fed moves in a big way, the GBP could be severely impacted. This would likely cause an increase in the cost of imports, thereby leading to inflationary pressures. This Fed has been sensitive to the plight of emerging market economies, especially since the quantitative easing policies were ended in 2013. Global growth is in a precarious predicament with the upcoming Fed announcements. Binary option traders have been capitalising off the market banter by placing call options on the USD ahead of any expected rate hike by the Fed. And put options on emerging market currencies appear to be a safe investment for binary options traders.