interest rates and economic cycles

Incident description

The relationship between Interest Rates and Economic Cycles

Economic cycles are characterized by alternating periods of expansion and contraction in the economy. These economic cycles can have an impact on interest rates, and, in many cases, the level of interest rates affects economic cycles. Right now, the Federal Reserve and other central banks have been raising interest rates in order to increase the cost of borrowing and hopefully slow down an overheating economy.

Benefits and Drawbacks

As we discussed in our last two blog posts, there are benefits and drawbacks to individual consumers and businesses of these higher interest rates. Today, we’re going to look at how you, as a consumer, can set yourself up to take advantage of both high and low interest rates.

Not too long ago, interest rates were low –very low. If you purchased a home with a fixed-rate mortgage or perhaps refinanced a fixed-rate mortgage during this period, you might have borrowed at rates around 3%. Now, you can get 4% on your money just by leaving it in a savings account. And, after a year when the S&P 500 dropped about 20%, a 4% return sounds lovely. During those years of low interest rates, finding places to get a decent return on your money with relatively low risk was difficult.

When investing, we look for an appropriate risk-adjusted return; in other words, we expect a higher return if we take on more risk. Interest rates were so low that many savers became investors simply because they couldn’t get a decent return on their money by saving and lending. They had to take on more risk to get a decent return. And fortunately for them, we experienced the longest bull market in history from 2009-2020.

A Balancing Act

balancing actWith higher interest rates, you have to do more of a balancing act between investing in equities like stocks or lending like purchasing bonds or other debt instruments. In an ideal situation, you would have funds to deploy in each case as soon as the balance shifted such that your comfort level (your risk tolerance) could be met and your desired level of return could be achieved. However, we don’t have crystal balls and don’t know if any given economic event is a blip or the beginning of a new trend. As interest rates have increased over the last year, we’ve never known if we have already hit the top. If we’re at the top of the curve, then, as a lender or saver, you would want to lock in return for as long as you can.

On the other hand, if you lock in and then interest rates rise again the following week, you may be kicking yourself. Or, if you recognized that mortgage rates were at their lowest in 2020, you could have locked in a nice, low cost of borrowing for 30 years. At the same time, if you believe that we’re at the top of the curve, you also have to think about how long you think interest rates will be high. If you believe that interest rates will start dropping in the near future, then you may want to start investing again on the theory that easier money conditions will allow for accelerated business growth.

The point here is that it is important to consider how economic cycles affect your individual financial situation. The “set it and forget it” method of financial planning may look like it works out for some folks. And, perhaps from a behavioral economic perspective, it has worked, i.e., they didn’t withdraw from their 401k because they weren’t thinking about their 401k. But, with a little attention, they may have been able to either reduce the risk in their portfolio or increase the return. Borrowing when the cost of borrowing is low – such as taking out or refinancing a mortgage–and lending when interest rates are high –such as purchasing treasuries and other bonds–is one method of taking advantage of the interest rates as we go through economic cycles.

Setting yourself up to make the most of interest rate changes is just one strategy you can use to reach your financial goals. Increasing or decreasing interest rates isn’t bad or good without context. It does come down to how you take advantage of them.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

Recommended Posts