If you aren't glued on finance news like me and missed the Federal Reserve’s announcement this past Wednesday, you may have noticed your investment portfolio had some strong reactions to it. Here are the two most important aspects of this week’s news and how practice owners might be affected:
1. The Federal Reserve is raising its rate (that is lends short term to banks) by 0.5%.
The rate that the Federal reserve lends to bank affects every other rate out there. So increasing it by 0.5% means other floating rate loans like credit cards, home equity lines and working capital lines also go up by 0.5%. An increase in short term rates does not necessarily mean long term rates will increase, but the Fed’s second part of its announcement means almost certainly that they will.
The Fed additionally signaled that it would continue to increase rates in 0.5% increments over the next few meetings and likely up by another 1.50% or more by the end of the year. So those floating rate loans—credit cards and lines of credit usually—will continue to get incrementally more expensive as the year goes on.
What to do with this news? This is a good time for practice owners to review their personal and practice debt structure to see if refinancing to a fixed rate loan makes more sense.
2. The Federal Reserve is letting its massive holdings of government bonds mature and will not reinvest into new issues.
A little background here: The Federal Reserve can do two things: set the rate (and amount) it lends to banks AND purchase government bonds. While the former (increasing rates) affects short term rates, the latter (buying bonds) impacts long term rates. Over the past few years, this buying of bonds has held interest rates artificially low. Not purchasing more means others will have to buy the bonds, typically at a higher rate than what the Federal Reserve has been willing to purchase at.
While this concept is a bit more complicated it has a lot of long term implications:
Increased long term rates for mortgages, student loans (I’ve been recommending my clients refinance even though the deferral program is still in progress), practice loans, equipment loans and other forms of fixed rate loans.
For a reference point, the difference on a 3% and a 5% $500,000 30-year mortgage is around $7,000 per year (remember the Fed is saying they will be raising short term rates by over 2% this year so this is not an unreasonable assumption). This spread across the entire economy is likely to have a cooling off effect of activity such as:
- Commercial real estate values as cap rates (what investors use to measure the value of a property) go up, which means values can potentially go down as commercial real estate as an investment isn’t as attractive
- Demand for homes, particularly second homes as they become less affordable. A side note on this is that supply has been a big issue with the current housing market so a decrease to demand doesn’t necessary mean prices will fall. Thankfully adjustable rate mortgages haven’t been as big of a tool in this market as in 2007, so while there are certainly headwinds it doesn’t necessarily mean there’s a ticking time bomb out there
- Private Equity and M&A activity where debt is used as a tool to finance purchases. I’m not familiar with the capital structure of the Keplrs, AEGs and My Eye Doctors of optometry but presumably there are implications for at least some of the major players in today’s market
I think most practice owners are familiar with the “why” behind all of this: Inflation. With I-Bonds yielding just shy of 10% and consumer CPI at a yearly rate of 8.5%-- the highest it’s been since 1981—the Federal Reserve doesn’t have much of a choice but to hit the brake pedal on a loose lending environment.
It’s not all bad news though… with change comes opportunity. When successfully mitigated, less inflation means more affordable groceries, gas, lower building cost and car prices, and hopefully an eventual decrease in rates. It also means bonds will become more attractive as rates go up, a big relief to conservative investors.
In the meantime, keep in mind that it’s likely to be a bumpy ride while the Fed makes it's upwards rate shifts and your investment portfolio should be structured to meet your long-term goals regardless of what the next year brings.
Hope to see you on the 17th!