The Impact of Rate Hikes
Many people fear that raising rates causes the stock market to fall. But does rising rates really affect your portfolio?
Key Takeaways
The Fed’s goal is to keep the US economy stable in two ways: maximizing employment and stabilizing inflation.
Inflation is the rise in cost of goods and services.
A common misconception is that rising rates will cause a bear market.
On January 11 2022, the Federal Reserve Chairman Jerome Powell testified before Congress that he plans to raise the federal funds rate in the coming year to fight inflation. What Powell didn't specify was exactly when and how much rates will rise.
The Fed’s only job is to keep the US economy stable in two ways: maximizing employment and stabilizing inflation.
They do this is by decreasing or increasing the federal funds rate which can impact interest rates throughout the economy. If the economy has grown rapidly and fears of inflation emerge, then the Fed typically responds by increasing interest rates.
Inflation is the rise in cost of goods and services.
Basically, it's how much your money loses value over time. While inflation typically goes hand in hand with economic growth, too much inflation can lead to a recession. For example, unprecedented levels of stimulus in COVID-19 supply constraints fueled a 7% rise in inflation during 2021 (the fastest increase since 1982). Many economists fear unchecked inflation could turn an economic boom into a bust. In response, the Fed signaled it had raised rates in 2022.
Here's how a rate hike works:
1) The Fed increases the federal funds rate, which is the rate banks use when they lend to one another.
2) This typically pushes interest rates higher overall, which makes it more expensive for businesses and individuals to borrow in promotes saving.
3) The goal is to reduce the spending that is driving up prices and overheating the economy.
4) Raising rates enough to slow inflation but not dampen the economy so much that it causes a recession is a tricky balance, but that's the Feds mandate.
So that's the big picture of how and why the Fed may hike rates.
Let's look at what impact it may have on your investments.
A common misconception is that rising rates will cause a bear market. This isn't true. The relationship between stocks and interest rates is complicated.
A BlackRock study found that from 1995 through 2020, when the 10-year Treasury yield rose more than half a percentage point, the S&P 500 rose on average of 3.2% over the following three months. But that doesn't mean rising rates don't impact stocks at all. Interest rates like the 10-year Treasury yield are used when calculating stock valuations using the discounted cash flow model and the impact could differ across the market. For example, higher interest rates may hurt growth stocks more than value stocks. The high valuation of growth stocks tends to be based on expectations of future profits. But rising rates can decrease the value of those expected profits, taking growth stock prices with them. Even just the expectation of the Fed raising rates can impact markets. Near the end of 2021, when the Fed became increasingly concerned about inflation, the S&P 500 pure value index started outperforming the S&P 500 pure growth index. The growth index started falling in November at a greater rate than value stocks and failed to rally as value stocks rally.
Let's look at specific stock sectors as well.
From 2002 through 2020, real estate was the best performing sector when inflation was rising. With a 1% increase in inflation, real estate tends to return more than 5%. Additionally, value sectors like energy, industrials, and utilities tend to perform well in those conditions.
Past performance doesn't guarantee future performance.
Financial stocks and, more specifically, bank stocks, tend to perform better when interest rates rise because it allows them to charge borrowers more. While rising interest rates aren't necessarily bad for stocks, they can be devastating to bond prices. Bond yields and bond prices move in the opposite direction.
Even just a 1% rise in rates could impact Treasury prices. The longer the maturity, the greater the effect of rising interest rates will have. Because rising rates are so tough on bonds, many investors may change their allocation in anticipation of rising rates by selling bonds and buying more stock. This flow of funds from bonds to stocks normally pushes stocks higher.
Keep in mind, it's not just the fact that rates are rising, but the speed at which rates rise that can influence your investments. Since the early 2000s, the Fed has commonly raised rates by just a quarter of a point each time. But in early 2022, some market analysts called for the Fed to use “shock and awe” tactics of large rapid rate hikes to rein in inflation.
There is some precedent for this.
In the late 70s, Fed Chairman Paul Volcker aggressively raised the federal funds rate several times to stave off double digit inflation. And in 1994, the Fed had two half point raises and one three quarter point raise. While the move did tamp down inflation fears it through the Treasury and mortgage-backed security markets into disarray. The Fed raised rates by a half point in May 2000, when the dot com bubble was bursting. Given this history, the Fed may be hesitant to raise rates more than a quarter of a point at a time, but it can increase the number of rate hikes instead.
Influential figures like JP Morgan CEO Jamie Dimon predicted the Fed could raise rates six or seven times in 2022, while others think three rate hikes are more likely. Whenever the Fed raises rates, investors should prepare for potential volatility as the markets adjust to a new environment. Areas of the market with high-leverage or low-liquidity may be the most reactive. But rate hikes can also be an opportunity for investors looking for higher yields from lower risk investments like bonds. Staying focused on your long-term goals can help you ride out rate hikes and cuts in any market swings that follow.