If you have a floating rate loan, own bonds or are planning on financing your company or buying a car in the future, you are facing interest rate risk. Interest rates fluctuate, sometimes widely, during an economic cycle, partly due to Federal Reserve monetary policy, which involves raising and lowering rates to manage the economy. Rates also fluctuate according to market demand for money. During boom times, rates rise because there is greater business and consumer demand for a limited supply of money to fund purchases. To forestall inflation, the Fed begins raising interest rates. This has the effect of cooling down aggressive borrowing, which is one factor in creating inflation. During recessions, the Fed lowers interest rates to spur the economy by making borrowing less expensive.
Monitor interest rates regularly and analyze charts depicting the movement of interest rates since 1950. Note how interest rates behaved during recessions and economic expansions. Pay attention to Federal Reserve comments on monetary policy.
Adjust your investment portfolio to accommodate anticipated movement in interest rates. It is better to sell your low-rate securities as soon as the first signs of impending higher rates becomes evident so you can avoid losses. Put your cash proceeds into U.S. Treasury bills or a money market account until rates have approached their highs. Interest on short-term investments will follow market interest rates higher.
Remain in your high-rate investments if interest rates are likely to decline. The prices of those high-rate securities will rise as the market rate falls, and you may be able to sell them at a profit when it appears rates will go no lower.
Borrow money for the long term when interest rates are low. If you're buying a house, a period of low rates is when you want to take a 30-year fixed-rate mortgage.
Keep your borrowings short-term during periods of high interest rates, then lock in long-term loans when rates go back down.
- Interest rate cycles historically average three to five years. This means that if rates are low, you can expect them to peak on the high side in approximately three years. There are exceptions to this, such as after the credit crisis of 2008, when the Federal Reserve had to keep interest rates low for an extended period of time to help the country recover from recession.
- When in doubt, ask an investment professional or read articles written by analysts who study interest rates. Your biggest risk if you own bonds is the period when interest rates are rising. You want to keep your investments very short-term during this period; buy long-term bonds only when interest rates are high.
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