How Do Interest Rate Hikes Impact Investments?
Interest rates are an area of the economy that is often overlooked until they begin to rise. The Fed raises interest rates to combat rising inflation and lowers rates to combat a slowing economy or high unemployment. Rate hikes or decreases are typically spread out over a period of months or years.
Overview of Interest Rates
The Federal Reserve raises interest rates across the US economy by raising the federal funds rate. The fed funds rate is a target range for the average interest rate that banks pay for overnight borrowing in the federal funds market. Changes to the fed funds rate spill over to impact other interest rates across the economy including the prime rate, auto loans, credit cards, and mortgage rates.
There are a number of factors that the Fed considers when changing the fed funds rate. For a recent example, until 2022 the Fed had kept interest rates low to combat the economic impact of the COVID-19 pandemic. As the economy recovered, the uptick in inflation has led the Fed to revert to more hawkish monetary policy by rising rates rapidly.
How Can Interest Rates Impact Investments
Interest rates mainly affect investors’ bond portfolios, as interest rates and bond prices have an inverse relationship. Rate fluctuations have not been correlated to stock prices, but can cause short-term market volatility.
Higher interest rates tend to impact investors in different ways depending on the allocation and time horizon of their portfolios. Bonds and bond mutual funds and ETFs are the most impacted by rising interest rates, but even investors not focused on fixed income can feel the affects of rate hikes. Rising rates impact cash accounts, CDs, money markets, alternatives, and almost any other asset class, the question is just of how they are impacted and by how much.
Interest Rates and the Stock Market
Rising interest rates don’t impact the stock market directly, but there tends to be a ripple effect.
First, rising rates can impact consumer spending as borrowing and paying off debt becomes more expensive.
When mortgage rates increase, it impacts the housing market and related businesses such as home builders and companies in the home improvement space.
Consumer spending can be impacted across the board as consumers see interest costs for credit cards, auto loans, and personal loans increase, leaving less disposable income to spend on consumer goods. This reduced spending can impact stocks across a number of sectors.
At a more macro level, rising rates can slow down the economy as the cost of borrowing increases. Higher interest costs can impact the bottom line of companies whose balance sheets include a significant amount of debt.
The overall dampening of stock returns can occur, as higher lending costs can drive down business growth and expansion. Rate hikes also tend to push investors towards investments with lower interest rates and a guarantee of delivering returns, which reduces demand for stocks and pushes prices down.
It’s also important to note that nothing has to actually happen for the stock market to react to interest rate changes. Stock prices are determined broadly by market sentiment, so if investors see rate hikes as an indication that businesses and consumers will cut back on spending, this can often cause stock prices to drop in anticipation.
Interest Rates and Real Estate
Rising rates can push home-buying out of reach for certain borrowers. At the same time, rising rates can be a boon for rental property owners, who may be able to charge higher rent prices if rental demand remains high.
As mortgage rates rise, the effect on real estate investing can be positive. The market for rental properties will increase because fewer people can qualify for mortgages. That said, rising interest rates can also reduce prices, so it can sometimes be better to buy during a rising interest rate environment.
Moreover, as interest rates rise, fewer real estate transactions take place as lending standards become tighter. Thus, more people will need rental properties until they can afford a mortgage. A 1% increase in interest for an investor can turn into a windfall of profit in the right housing market.
Interest Rates and the Bond Market
Interest rates directly impact bond prices and the return on certificates of deposits (CDs), Treasury bonds, and Treasury bills.
Bond prices are negatively correlated with interest rates, meaning as interest rates rise, bond prices usually fall, and vice-versa. The longer the maturity of the bond, the more it fluctuates in response to changes in the interest rate due to duration risk.
However, this impact should be put into perspective with volatility. If rising rates occur during a bear market, bonds can still offer consistent income and help to mute portfolio volatility over time.
When the Fed raises interest rates, newly offered government securities such as Treasury bills and bonds are often seen as the safest investments. In other words, the risk-free rate of return increases with interest rates, making these investments more desirable.
In periods of economic uncertainty, bonds tend to be more appealing to investors concerned with the possibility of a market correction, AKA a 10-20% drop in stock prices.
What Stocks Traditionally Benefit From Rising Rates?
The Fed raises rates as an attempt to stifle inflation caused by an overheating economy. By making credit more expensive and more difficult to obtain, certain industries that do not rely on economic growth may be well positioned.
These industries can include consumer goods, lifestyle essentials, and industrial goods. Companies that don’t carry a lot of debt on their balance sheets are also less likely to suffer from rising rates.
Certain stock sectors can also benefit from rising rates as they suggest stronger economic growth. Cyclical industries such as financial services, industrials, and energy providers tend to perform better when rates rise.
Real estate investment trusts (REITs), utilities, consumer staples, and telecommunication (RUST) companies are some that investors tend to keep an eye on when rates begin to climb.
The financial sector has historically been one of the most sensitive to interest rate changes. Financial firms such as banks, insurance companies, brokerage firms, and money managers typically see profit margins expand as rates climb.
The Bottom Line
Macroeconomic changes can often prompt investors to reexamine their portfolios and investment strategies, but full rehauls of long-term strategies are rarely a good idea. While there may be potential opportunities in certain asset classes and sectors, high inflation is something that the US has not experienced in a few decades so past trends likely don’t take modern variables into consideration.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.