If there’s one thing the markets have taught us over the years, it’s to expect the unexpected. That’s certainly been the case lately with the potential market impacts of rising rates. The United States is experiencing inflation that is growing at rates not seen since 1982 and many investors are reacting by selling bonds and pushing yields higher. The S&P 500 (SPX), Nasdaq Composite (COMP), and Dow Jones Industrial average ($DJI) are struggling with the changes as many investors are shifting their allocations. Many are selling consumer discretionary and technology in favor of energy, materials, and financial stocks. Others are reducing their exposure to growth stocks to focus on value stocks. The Federal Reserve and many central banks around the world can no longer maintain accommodative policy and are ending their economically stimulating bond-buying programs and targeting rate hikes.
The Fed has been extremely cautious about changing its monetary policy too fast to avoid slowing a fragile economic recovery from the effects of the COVID-19 pandemic. But it’s starting to look like the Fed could hike rates by the very least 25 basis point in March. The CME Fed futures are actually predicting about a 64% chance of a 50 basis point hike at the Fed’s upcoming meeting in March—these probabilities can change on a daily basis and are impacted by many factors including global markets, politics, and more. So, what’s changed that’s increasing the market’s expectations for the Fed to hike rates faster?
There’s a ton of factors the Fed evaluates when deciding its monetary policy. Inflation, economic growth, and interest rates are all intertwined and changes to one will impact the others to some degree. The Fed’s dual mandate is to maximize employment and stabilize prices. Several Fed governors and Jerome Powell have taken a more hawkish tone as the U.S. inflation has grown at more than 7% year over year. The labor market remains close to maximum employment, with numerous job openings going unfilled, which gives the Fed confidence it can raise rates without hurting workers. But there’s still a lack of detail surrounding the specifics of many of these plans and policies because Chairman Powell wants to allow the month-to-month data to dictate its decisions. The uncertainty appears to be frustrating investors who want to know how the Fed plans to curb inflation that seems to many experts to be getting away from the Fed.
Bear in mind that stronger economic growth can often cause higher inflation and higher employment levels, which are the two big determinants of when, how much, and how quickly the Fed will raise interest rates. We know the Fed will eventually raise rates; we just don’t know when future rate hikes will occur and their size. Economies and markets worldwide also have an impact on the Fed’s rate hike decisions. This makes it difficult to try to predict the future movement of interest rates. But we can look at some of the impacts of rising rates on different markets and think about how it might impact portfolio allocations.
Fixed Income Investments
Bond prices and yields are inversely related. The terms “yields” and “interest rates” are often used interchangeable because the yields found in the money markets help determine interest rates. So, when interest rates rise, bond prices fall and vice versa. However, a rise in interest rates doesn’t impact all fixed income investments equally. Generally, the longer the maturity—or duration—of your bond or bond funds, the greater the impact of rising rates.
The price of lower coupon bonds and bonds that pay a fixed coupon can be more affected by rising interest rates than bonds with a floating, or step-up, rate. This is because the coupon on floating rate bonds is pegged to a benchmark rate like LIBOR, which is impacted by changes in the federal funds rate and will rise if rates are increased.
For investors who hold bonds to maturity, a rise in rates will not have an effect on the coupon payment you receive, or the principal payment you receive when that bond matures, barring bankruptcy or other credit event. But the bond price will likely fall in value when rates rise. So, if you need to liquidate your bond prior to maturity, you may incur a loss on your investment. This could have a big impact on investors who bought bonds with maturities that weren’t consistent with their liquidity needs and risk tolerance.
Impact of Rising Interest Rates on Stocks
Rising rates can make some stocks less attractive because of the way analysts calculate a stock’s intrinsic value. Generally, this means that growth stocks tend to become less attractive and value stocks tend to be more attractive. And because rising interest rates make bonds less attractive, many investors will turn to stocks. Additionally, some sectors tend to perform better during rising rates. For example, banks and financial companies that earn money from borrowing and lending can benefit from rising rates because higher rates often increase the spread between lending and savings. Depending on what economic policies are enacted and how quickly interest rates rise, it might not have as strong of an impact on the attractiveness of stocks.
Over time, if the market anticipates the Fed is nearing the end of its rate hiking cycle, then you may see stocks with higher dividends decline as investors rotate back into fixed income investments. This will depend on competing yields and a desire for safety. At this point, many have expected rates to rise for quite some time, so it’s possible stock valuations could reflect this to some extent.
The U.S. dollar has rallied since the summer of 2021 as investors have looked to higher yields in the United States. If rates continue to rise, they could push the dollar even higher. This is usually a negative for large, multinational companies that generate a larger portion of earnings abroad. A stronger dollar makes their goods more expensive abroad, which could lead to reduced demand in certain countries and reduced profit margins.
Whether you’re evaluating a potential investment or your current portfolio, consider the economic and market conditions that could have an impact on its return. A rising rate environment impacts different investments in different ways. What’s important is investors have a plan before interest rates rise. A well-diversified portfolio is typically is one of the best defenses against market movements (although, diversification does not eliminate the risk of experiencing investment losses). Anytime market conditions are shifting in a big way, it’s a good time to examine your portfolio and risk exposure to make sure it lines up with your investment goals. If you’re not comfortable with your risk exposure, it could be time to slowly start making some changes.
What to Expect When the Fed Raises Interest Rates