Fed’s rate hikes ripple through economy
BY TERRY SAVAGE SUN-TIMES COLUMNIST Jul 14, 2006
Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
What do speculators, students, shoppers and homeowners have in common these days? They’re all more exposed to rising short-term interest rates than they might realize. The combination of inflation fears, Federal Reserve rate increases and a falling stock market could be a potent and destructive cocktail for the economy.
The stock market now is taking seriously the Federal Reserve’s determination to raise interest rates.
Speculators who borrowed money to buy shares are finding that the cost can’t be calculated simply by short-term interest rates. After all, it made sense to pay the broker call money rate of about 8.5 percent to borrow on margin if you were expecting double-digit monthly gains. But when stocks drop instead of rising, there’s a double whammy: Not only do you have to pay the lender, but you have to ante up more cash to maintain your position in hopes of getting even.
Rumor has it that plenty of stock market speculators tapped their home equity to place a bet on rising stock prices. Now they are being called to put up more money, just as the interest rates on those home equity loans are moving higher. If your home equity loan is based on the 90-day Treasury bill rate, you could find a significant increase in monthly payment costs the next time your bill is recalculated. Treasury bill rates have climbed from 4.36 percent a year ago to 5.80 percent today.
Home equity loans have been used for more than stock speculation. It’s been hard to escape those commercials and mailings enticing you to “consolidate your credit card bills with one low-interest rate, tax-deductible home equity loan.” True, on the face of it. Home equity loans are amortized differently, resulting in a lower monthly payment which may be tax deductible.
But interest rates on a home equity loan tend to float--and these days, they’re floating higher.
Bank Rate Monitor, which tracks loan rates, says that the average on home equity loans has risen half a percentage point--from 8.73 percent at the start of this year to 9.21 percent this week. Rising rates means rising payments. And more money spent on loan payments means less money spent at the stores. Or rising bankruptcy rates.
Here’s another group of borrowers about to get hit with rising interest rates. Student loan rates on federal Stafford loans are variable and adjusted annually on July 1--based on the last 90-day Treasury bill auction rate in May. According to Robert Murray of USA Group, one of the largest student loan servicing companies, rates on outstanding loans could rise as much as 1.25 percent in July. Some loans will hit their lifetime caps of 8.25 percent.
Those who still are making payments on student loans should immediately consider official student loan consolidations to lock in the current lower rates.
The consolidation process can take as long as six weeks, so it’s wise to start now. (For more information, call USA Group at 800-448-3533 or use the interactive calculator at their Web site: www.usagroup.com.) A borrower with $20,000 in student loans could save nearly $1,000 in interest costs over a 10-year repayment period by locking in today’s lower rates.
The stock market’s wealth effect made a lot of people comfortable with borrowing money at floating rates. After all, everyone “knew” that you’d more than make up for interest payments with increases in your net worth. But rising interest rates carry their own type of leverage in an economy that has more than $520 billion in credit card debt, not to mention an additional $270 billion in margin debt, and an estimated $100 billion in floating rate home equity debt, along with nearly $1 trillion in variable rate mortgage debt.
For a long time, market bulls have argued that the “new” tech economy was not vulnerable to higher interest rates. Maybe so, but the workers in the new economy who bet on rising stock and option prices, and then leveraged their budgets on floating-rate debt will certainly be affected if the Fed moves short-term rates higher again.
And even ordinary citizens who aren’t directly invested in the stock market will feel the impact of higher rates if a falling stock market causes a “reverse wealth effect.” If spending slows as investors retrench, then store clerks, real estate agents and car salespeople who have been stressing out over the possibility that the Internet will steal their jobs, will find that the old economy reduces their paychecks in an old-fashioned way.
It’s entirely possible that the current stock market volatility will force the Fed to stay its hand, in fears of raising rates again at just the wrong time. And the market could once again ignore the most recent actions of the nation’s central bank, and go roaring ahead. But just as it makes sense to “stay invested over the long run,” there’s another market maxim now in play: “Don’t fight the Fed.” Those who ignore these two rules do so at their peril. And that’s the Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail at firstname.lastname@example.org. Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.