Exactly one week from today, the Federal Reserve is expected to raise its benchmark interest rate, the federal funds rate. It will be the first time interest rates have gone up in the U.S. since 2006.
Consumer Spending to Be Affected by Higher Interest Rates
Higher interest rates and consumer spending have a negative relationship, meaning spending moves in the opposite direction of interest rates. As interest rates rise, consumer spending will fall. (For this reason, I am expecting only a minor rate increase from the Fed at this time.)
When we look at the chart below of the year-over-year percentage change in retail and food services sales in the U.S. economy, we see consumer spending is already pulling back. Bottom line: a small rate increase is bad for consumer spending because of the negative connotation higher rates put on consumer confidence.
Second Victim of Higher Interest Rates: U.S. Housing Market
Rising interest rates are the single biggest drag on the housing market as higher rates make homes less affordable for Americans.
The chart below is of the percentage change in sales of new one-family homes in the U.S. economy. As the chart shows, just the threat of higher interest rates has pushed housing sales down.
Third and Biggest Victim of Higher Interest Rates: Bonds and Stocks
Finally, higher interest rates will push bond prices downward and bump bond yields higher.
The yield on the bellwether 30-year U.S. bond has been rising since April of 2015, when “noise” of higher interest rates first started to surface.
Chart courtesy of www.StockCharts.com
Since February, yields on the U.S. 30-year bonds have jumped 30%. Keep in mind that 30-year bonds are considered the “safest” bonds. If you look at other bonds, such as corporate or junk bonds, their yields have soared even higher.
As for the stock market, low interest rates have been a godsend for stock prices since 2009. As the Federal Reserve took interest rates down to zero, investors moved into stocks, as they chased the highest possible return for their money. They even borrowed at a record pace to invest in stocks: margin debt on the New York Stock Exchange (money borrowed to buy stock) is now near a record $471 billion. (Source: New York Stock Exchange, last accessed December 7, 2015.)
Low interest rates also enabled public companies to borrow funds on the cheap to buy back their own stock, thus reducing the amount of stock in the market and pushing stock prices higher.
Higher interest rates will increase the interest expense of companies (making them less profitable), reduce the amount of money investors borrow to buy stocks (less demand for stocks), and increase the cost of public stock buyback programs (taking away an important built-in floor for the stock market).
Yes, I know it will be only a small interest rate increase next Wednesday and I know it might be only a one-time event if the economy worsens in 2016 as I expect. But combine higher interest rates with a pull-back in consumer spending, falling demand for houses, a declining bond market, and the continued contraction in earnings and revenue growth for S&P 500 companies…and we have a disaster on our hands for the stock market next year.