Interest Rate Hike 101: How Changes to the Fed Can Affect Your Investment Strategy
Interest rates have jumped, but inflation has barely slowed and growth has continued. Should you change your investment strategy?
To deal with this new crisis, the Fed bumped up interest rates, and by May 2023, rates stood at 5.25% — 21 times higher than they were just one year earlier. Interestingly, the Fed's aggressive strategy on interest rates hasn't slowed the economy or inflation as much as they hoped. Core prices are still accelerating, hiring is up, and the economy appears resilient.
Consequently, many economists and market watchers expected the Fed to raise rates yet again this year — maybe twice. Facing this unusual matrix of runaway inflation, interest spikes, and economic growth all coming at the same time, many consumers and investors worry about their financial futures.
What are recent interest rate hikes doing to your wealth, and should you change your investment strategy? Let's take a look.
A Brief Guide to the Federal Reserve System
The Federal Reserve, commonly called "the Fed," has served as the central banking system of the United States since 1913. The Fed's main objective is to promote a stable and healthy economy. To do that, it controls the money supply, supervises banks, and implements monetary policies.
One of the primary tools the Fed uses to influence the economy is the federal funds rate, also known as the Fed rate. This is the rate at which banks can borrow funds from each other overnight to meet their reserve requirements. The Fed raises or lowers the rate in order to either strengthen or soften economic growth.
The Fed rate is not the same rate as the APR you might get for a consumer loan, but other forms of debt, such as credit cards, mortgages, and auto loans, are definitely tied to the Fed rate. When your bank pays more money to borrow more money, you pay more money to borrow more money.
And your bank is definitely shelling out more money to borrow more money. Here's why…
The Relevant History of Modern Interest Rates in the U.S.
In December 2008, the Fed tamped down rates to 0% to help the economy cope with the Great Recession. As economic conditions improved, rates slowly crept up until 2019. Then, they dropped to 0% again during much of the COVID-19 pandemic.
Between March 18, 2008, and September 21, 2022, the Fed rate never exceeded 3.0%. Today, that rate is 5.25%. What happened?
Following the Great Recession, the Fed hesitated to change interest rates. Then came Coronavirus, and the goal of keeping the rate so low was to stimulate economic activity during COVID. However, once COVID was over, inflation — not economic shrinkage — threatened the global economy.
On March 17, 2022, the Fed announced its plans to increase interest rates. The move came amid concerns about rising prices in key areas such as housing and consumer goods. This decision marked a shift from the low-interest-rate environment that had been in place for several years and signaled a new phase of economic policy.
Since then, the Fed has continued to raise interest rates, with the most recent hike coming on March 2, 2023. Ongoing inflationary pressures and an improving labor market have fueled these rate increases. However, some experts are concerned that the Fed's continued rate hikes could further stifle economic growth, increase unemployment, and dampen investor sentiment.
After all, when interest rates go up, corporate profits tend to go down. When profits go down, layoffs occur, stock prices dip, and investment portfolios often lose value. Stocks, bonds, commodities, real estate, and any other investment not locked into a conservative, stable rate of return is often affected.
Post-COVID changes to interest rates have had far-reaching implications for investors and consumers alike. Credit is tight, growth is slow, and inflation is still high. What is the Fed doing about it all?
How Recent Monetary Policy Shifts Affected Investments
Since the onset of the pandemic, the Federal Reserve has made several monetary policy shifts to support the economy. When the pandemic began, the Fed dropped interest rates dramatically and bought up $1.7 trillion in Treasury bonds. It also supported paycheck protection and small business lending programs. These actions, along with household stimulus checks, kept currency circulating in the market, even though commerce had slowed to a crawl.
When the pandemic ended, the Fed turned its focus to economic recovery and fighting inflation, raising the rate 10 consecutive times between March 2022 and June 2023. Its goals include maximum sustainable employment, moderate long-term interest rates, and price stability. Specifically, the Fed wants to keep inflation rates at about 2% per year.
So far, the Fed might say it has been successful at its biggest goal: the U.S. economy has stayed out of a formal recession since the COVID pandemic eased. However, inflation remains high, and economic indicators have shown troubles could yet lie ahead. The Fed is still making regular moves to head off more problems.
Its challenge lies in the tenuous balance between economic growth and price stability. It's tough to get one without giving up the other.
Why Would the Fed Want to Slow Economic Growth?
A strong, fast-growing economy usually means that most companies are making a profit, unemployment is low, and consumers are spending freely. These are all great signs, right? If almost everyone has a job, and companies are growing, what could be wrong with that?
Unfortunately, a growing economy also means a higher cost of living. For companies to hire more people and pay better wages, they have to increase their prices. If you're getting regular raises or terrific returns on your investments, then you're probably paying higher prices for housing, groceries, and gas. As harsh as it sounds, wage stagnation and higher unemployment are good for price stability. They're just bad for growth.
That's why the Fed monitors inflation closely as part of its mandate to promote economic stability and maintain full employment. When it raises rates, people buy fewer goods and services, and prices remain steady or drop, a phenomenon known as deflation. When the Fed lowers rates, consumers tend to buy more products, swelling the economy but bumping up prices, too.
As an investor, you might want to be aware of the potential impacts of changes to the Fed rate and adjust your investment strategies accordingly. For example, during periods of rate hikes, you might consider shifting more of your portfolio towards cash, bonds, or other fixed-income assets. However, it's essential to remember that timing the market is extremely difficult! We generally caution our clients against it. If you are wrong it could be costly.
Remember, each asset class brings its own unique risks and rewards, and investors should generally take the time to evaluate each investment option carefully in cooperation with their wealth management professional.
Inflation and Its Implications on Your Portfolio
Inflation is a term that is often heard in financial circles, but why is it so important?
What is Inflation?
Inflation refers to the speed at which prices for a basket of consumer goods and services rise in a window of time. It sounds simple, and it is… kind of. Economists cite a specific percentage when talking about inflation. (Currently, it's 2.97%.) Clearly, not every good and service in America costs 2.97% more now than it did last month. So what does that percentage actually refer to?
Economists determine the inflation rate by looking at the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The CPI is derived from the price fluctuations in a basket of goods and services that meet consumers' primary needs, including food, transportation, and medical care. The WPI measures the price of goods before they sell at retail.
With this data, economists use a specific formula to calculate inflation:
[ (New Price − Old Price) ÷ Old Price] × 100
For example, if a cup of coffee costs an average of $1.05 in 1996 and $2.35 in 2023, then you would fill in the data and work the equation as follows:
[ (2.35 − 1.05) ÷ 1.05] × 100= 123.80%
If you're interested, you can use the Bureau of Labor Statistics' CPI calculator to see how much a dollar from a previous year would purchase today. (It's eye-opening!)
What are the Effects of Inflation on Investors?
Financial or economic terms often create big feelings in the listener. "Growth" sounds great, for example, but "inflation" can feel intimidating. However, it's important to understand that inflation isn't all bad and rapid growth isn't always best for the economy.
Investors who own property or commodities may actually see the value of their investments rise during an inflationary period. If you bought a home for $500,000 and sold it a few years later for $600,000, for instance, then you likely benefited from inflation.
People who hold a lot of money in cash, however, are likely to see their investments lose value when inflation increases.
During inflationary periods, some investors put money into new ventures, which they believe will outperform traditional corporate earnings. And of course, inflation helps slow spending, since your dollar no longer goes as far, people often can’t afford the same things they used to..
Some inflation is inevitable, even helpful, to the economy. However, runaway inflation is never good. Businesses, consumers, and investors can have trouble determining when to buy, sell, or hold their assets since high inflation makes future prices unpredictable. The rates of inflation in post-COVID economies have been too high, and the federal government is trying to manage them without damaging economic recovery strategies.
How the Fed Copes with Inflation
The Fed has implemented various policies over the years to help manage inflation and keep it under control. One such policy is the interest rate hike.
What is an Interest Rate Hike?
An interest rate hike is an increase in the federal funds rate, which is the interest rate at which banks borrow money from each other. When the Fed raises interest rates, it aims to slow down the economy by making borrowing more expensive, thereby reducing spending and curbing inflation.
When interest rates rise, borrowing becomes more expensive. This means that businesses and consumers are less likely to take out loans, reducing the amount of money flowing through the economy. In turn, this can help to lower inflation rates.
Another reason for the Fed rate hike may be to strengthen the US dollar. When interest rates rise, foreign investors may be more likely to invest in US financial markets, which can drive up the value of the US dollar. A strong dollar can be beneficial for American businesses, as it can make imported goods cheaper and help to reduce the trade deficit.
An interest rate hike can have a ripple effect throughout the economy, impacting everything from mortgage rates to credit card interest rates. It can also impact the stock market and other investment vehicles.
If the Fed raises rates too high and too fast, then the economy can go into a recession. A recession generally happens when the gross domestic product is negative, spending is low, and unemployment is high.
Ultimately, the decision to raise interest rates is a complex one that takes into account a wide range of economic factors. The Federal Reserve must balance the need for economic growth with the need to control inflation and maintain stability in the financial markets.
How Does an Interest Rate Hike Affect Investors?
Inflation and interest rate’s impact on different investment sectors can vary greatly, depending on the nature of the investment and the overall market conditions.
For example, bonds tend to be sensitive to changes in interest rates, and rising rates can cause the value of existing bonds to decline. Conversely, stocks may not be as sensitive to interest rate changes but may suffer if inflation becomes too high and causes the overall economy to slow down.
To mitigate the impact of inflation, investors might consider inflation-protected securities or commodities. Inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS), are designed to provide a return that adjusts for inflation, thereby protecting the purchasing power of the investment.
Commodities, such as gold and oil, have historically been viewed as a hedge against inflation. As prices for goods and services rise, so too do the prices of commodities, making them an attractive investment option for those looking to hedge against inflationary pressures.
Interest rate hikes do generally promise one thing for investor’s - higher money market returns and returns on savings accounts. Most local bank branches have yet to raise their rates, but online savings accounts such as Ally or Capital One have increased their rates accordingly. However, hanging out in cash carries its own risks.
Consider working with a qualified wealth manager to create a cohesive, resilient, and robust investment strategy. .
Market Volatility and Risk Management
When the Federal Reserve announces an interest rate hike, it can create uncertainty and volatility in the market.
Investors should be aware of the potential impact of an interest rate hike on their investment portfolio and consider implementing risk management strategies prior to that time. One key strategy is diversification. By investing in a mix of assets, such as stocks, bonds, and real estate, investors can mitigate the impact of market fluctuations.
Another important strategy is asset allocation. Investors should assess their risk tolerance and investment goals and allocate their assets accordingly. For example, if an investor has a shorter investment horizon, they may choose to allocate more of their assets to fixed income investments that are less volatile.
Risk mitigation techniques can also help investors navigate a dynamic market environment. Hedging strategies, such as options or futures, may help investors protect against downside risk. Additionally, active portfolio management aims to help investors adjust their investments in response to changes in the market.
How Interest Rate Hikes Impact Key Economic Sectors
The impact of a Fed rate hike is not limited to a particular industry. The effects can be felt across most sectors of the economy. However, certain sectors tend to be more sensitive to changes in interest rates, and understanding the potential implications can help investors make more informed decisions about their portfolio.
Banking and Financial Services
Banks and financial services companies are among the sectors most affected by interest rate changes. This is because banks rely heavily on the spread between their borrowing and lending rates, which can narrow during periods of low-interest rates.
When the Fed raises interest rates, it can boost profits for banks by increasing the spread between borrowing and lending rates. However, it can also lead to higher borrowing costs for consumers, which can reduce demand for loans and hurt profits for banks. Some smaller banks, while often a lapse in judgment, may also find themselves in trouble if they were heavily invested in longer-term bonds with lower rates.
Technology Companies
Technology companies can get hit hard when the economy cools off. The Fed's decision to raise interest rates in 2022, tech stocks generally traded lower than stocks in other sectors despite tech companies outperforming the market overall during COVID.
This probably happened for several reasons:
Higher borrowing costs likely reduced consumer spending and led to weaker demand for technology products.
Most tech companies are priced for growth with often very high PE ratios. It only takes a small reduction in profits for such stocks to have their prices fall and profits typically take a hit when interest rates rise.
Many tech innovations fail after their market debut, making the sector itself volatile and risky.
Oil, Gas, and Energy
Remember that inflation is often good for commodity prices. Therefore, measures to halt inflation are generally bad for those same prices. Energy companies are often among the most affected commodity suppliers since oil and gas consumption tends to drop whenever the economy slows down. A rate hike can also lead to a stronger dollar, which can lower commodity prices and hurt energy companies.
We are not living in typical times, however. Right now, interest rates are higher than they have been in over 15 years, but gas prices are still sky high. That's because more factors than just interest rates help determine commodity pricing. The Russia-Ukraine War is one of those factors, and it's helping inflate commodity prices despite the Fed's moves on interest rates.
Consumer Goods
Higher borrowing costs can reduce consumer spending, which can lead to lower demand for consumer goods and hurt profits. Eventually, if the rate hikes are successful at bringing down inflation, consumer goods prices could drop. Buyers typically experience the pain of the rate hikes before the relief of softer inflation, however.
How to Mitigate Sector-specific Risks
Mitigating risk associated with changing Fed policies often requires diversification across multiple sectors and asset classes. Investors should consider building a well-diversified portfolio that can withstand market volatility and protect against sector-specific risks. This can include investing in a mix of stocks, bonds, and alternative investments that are less impacted by changes in interest rates.
How Interest Rates Can Impact Your Wealth
If you're invested in the stock market, bonds, or real estate, then a Fed rate hike can have a significant impact on your investment portfolio. Interest rates play a vital role in the economy, influencing spending, borrowing and saving.
Bonds and interest rates are directly related. When the Fed raises interest rates, bond prices drop. This is because when new bonds are issued, they have a higher yield due to the increase in interest rates. If you own a bond, the value of your bond may decrease if you sell it before maturity.
Stocks and interest rates have a more indirect relationship. If the Fed raises interest rates to control inflation, this could result in a slowdown of the economy, which can impact companies' revenue and earnings. Companies may also experience higher borrowing costs, leading to lower profits and stock prices.
Real estate can be impacted by interest rate hikes as well. When the Fed raises interest rates, it becomes more expensive to borrow money for a mortgage, potentially slowing down the real estate market.
If interest rates are rising, it may be the right time to review your investment portfolio and think about risk management strategies. If you’re concerned about future interest rate hikes and your investment portfolio, it may be the right time to reconsider your overall strategy. Consider diversifying your portfolio by investing in multiple asset classes — stocks, bonds, and real estate. You may also want to talk to your wealth management advisor about adjusting your allocation towards more defensive sectors that are less impacted by interest rate hikes or other economic events in the future.
Bonds and Interest Rates
One of the most significant impacts of a Fed rate hike happens on the bond market. Bonds, which are essentially loans to corporations or governments, pay out interest to their owners. When the Federal Reserve raises interest rates, older bonds become less attractive to investors. This is because new bonds that are issued will pay a higher interest rate, so existing bonds become less valuable in comparison.
For example, suppose an investor owns a 10-year bond with a 2% interest rate. If the Federal Reserve raises interest rates to 3%, new bonds will pay out more in interest, and the value of the 2% bond decreases to compete with them. Investors may try to sell off their bonds in response, which can cause bond prices to drop and interest rates to rise even further.
In general, when interest rates rise, bond prices fall. This inverse relationship is a fundamental aspect of bond investing. However, different types of bonds may react differently to an interest rate hike. Bonds with lower credit ratings, for example, may also be more susceptible to interest rate changes.
So, what should bond investors do if interest rates are rising? One option is to hold your bond to maturity. Doing so will likely reduce your chances of a loss, allowing you to collect (or get back) the face value of the bond when it becomes due. Another option is to consider short-term bonds. Short-term bonds are less sensitive to interest rate hikes than long-term bonds. You may also consider diversifying your bond portfolio. Holding a mix of short-term and long-term bonds can help balance out the impact of interest rate changes.
Overall, while a Fed rate hike can impact the bond market, it is important to remember that bonds remain an important part of many diversified investment portfolios. By understanding the potential risks and taking steps to manage them, you can still benefit from the stability and income that bonds can provide.
Stocks and Interest Rates
The Fed rate may not directly fuel the market, but it will almost certainly impact your stock holdings. Generally speaking, higher interest rates can cause stocks to experience downward pressure, particularly for companies that rely heavily on borrowing to finance their operations.
The rationale behind this is simple: as interest rates increase, the cost of borrowing goes up, which can put pressure on a company's bottom line. This can be particularly acute for companies that have a lot of debt on their books, as their interest expenses can start to eat into their profits.
However, it's important to note that the impact of a Fed rate hike on stocks can vary depending on a variety of factors, including the health of the overall economy and market sentiment. Additionally, some companies may be better positioned to weather interest rate hikes than others.
If you have a diversified portfolio of stocks, it's likely that you will experience some short-term volatility in the wake of a Fed rate hike, but this could be balanced out by long-term gains.
Overall, while an interest rate hike can certainly impact your stock holdings, it's important to maintain a long-term perspective and not make any rash decisions based solely on short-term volatility. With a well-diversified portfolio and a focus on risk management, you may be able to navigate the ups and downs of the market and position yourself for long-term success.
Real Estate and Interest Rates
The real estate market is almost immediately responsive to the Fed's maneuvers. However, if you currently live in Southern California you may beg to differ. Despite this, interest rates directly influence mortgage rates, which means that an increase in the Fed rate can lead to higher mortgage rates for homebuyers and homeowners looking to refinance. This often results in a slow down in the housing market.
As a result, real estate investment trusts (REITs) can also be impacted by a Fed rate hike. Typically, rising interest rates can make REITs less attractive to investors since they become less competitive with other investments that offer higher yields. However, certain types of REITs, such as those specializing in commercial properties or multifamily residential buildings, may be less impacted by rising interest rates compared to other types of real estate investments.
If you are looking to buy or sell a home, be aware that an interest rate hike can have an impact on the affordability of properties. Higher interest rates mean that mortgage payments will be higher, potentially causing prospective buyers to opt for lower-priced homes or hold off on purchasing altogether.
On the other hand, rising interest rates can lead to lower home prices, as there may be fewer buyers looking to purchase a home if the monthly payments are too high.
Overall, if interest rates are expected to rise, it may be beneficial to consider locking in a mortgage rate or selling a property before the market becomes less favorable. As with any investment decision, it's important to assess the risks and potential rewards before making any moves in response to a Fed rate hike.
What Should You Do if Interest Rates are Rising?
As an investor, a Fed rate hike could affect your investment portfolio in a number of ways. It's important to be proactive and have a solid plan in place to help mitigate any negative effects that may arise from any changing economic condition.
Here are some things to consider when interest rates are on the rise:
Pay off credit card debt. Americans owe about $930 billion in credit card debt. When interest rates go up, it gets a lot harder to pay back that money because the total cost of your loan increases. If you haven't already cut up your credit cards, now is a good time to break out your scissors and stop using any card you currently have a balance on.
Don't take out car loans or student loans. Debt is never good, and it can be especially bad for your financial health when interest rates are high. Taking out a loan right now can be expensive. If you simply must borrow money, wait until rates drop to do it. (Or better yet, save up cash and buy what you want outright.)
Brace yourself for higher payments if you have an adjustable rate mortgage (ARM) or a HELOC. You may have gotten an attractively low interest rate when you took that loan, but you are about to experience the dark side of that loan.
Review your current portfolio: Ideally this is something you would have done before interest rates rise, but it’s never too late. Take a closer look at your investments and determine which ones may be affected by a change in interest rates. Reassess your overall risk tolerance and consider making adjustments if necessary.
Diversify your holdings: Investing in a variety of assets, such as bonds, stocks, and real estate, can help spread out risk and potentially protect your portfolio from market volatility. Ecclesiastes 11:2 says, "Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land."
Consider shorter-term investments: Shorter-term investments such as bonds or savings accounts may be less affected by rising interest rates, so consider reallocating some of your assets into more short-term holdings. But use caution, stay in short-term too long and you may miss the opportunity for added growth
Avoid making rash decisions: Although an interest rate hike may trigger market volatility, it's important to resist the urge to make impulsive decisions. Stay calm, review your options, and make thoughtful decisions that align with your long-term goals.
Consult with a financial advisor: At Cooke Wealth Management, we can help guide you through a Fed rate hike and provide valuable insight into how to adjust your investment strategy.
Overall, it's important to keep in mind that interest rate hikes are a normal part of the economic cycle, and while they can certainly have an impact on your investment portfolio, they shouldn't trigger panic or knee-jerk reactions. By staying informed, being proactive, and making thoughtful decisions, you can navigate changes in interest rates and help protect your portfolio over the long term.
Global Perspective and International Investments
The global economy is intricately connected, and changes to the Federal Reserve's policies can have ripple effects across the world.
First, when the Fed raises interest rates, the value of the dollar tends to increase. This can make U.S. investments more attractive to foreign investors, potentially leading to increased demand and higher prices for U.S. assets. However, a stronger dollar can also make U.S. exports more expensive, potentially hurting American businesses that rely on overseas sales.
On the other hand, countries with weaker currencies may face challenges in response to a Fed rate hike. Foreign investors may pull out of those markets in search of better returns elsewhere, leading to a decrease in demand for their assets and potentially causing their currencies to weaken even further.
It's also worth noting that not all countries have the same monetary policies as the United States. Some central banks may raise or lower their interest rates in response to the Fed's actions, while others may choose to maintain their current rates. This can create opportunities for investors to take advantage of disparities in interest rates between countries, potentially earning higher returns through international investments.
Overall, the impact of Fed rate hikes on global markets and economies can be complex and far-reaching. However, with careful analysis and strategic planning, investors can adapt their portfolios to take advantage of shifting dynamics and potential opportunities for growth.
It's important to keep a global perspective on your investments, particularly if you have international holdings. The impact of a Fed rate hike can differ across countries and regions, so make sure you consider the potential impacts and make adjustments as necessary.
In summary, a Fed rate hike can impact your investment portfolio in various ways. Be mindful of your investments, consider risk management strategies and take a global perspective to manage the effects of interest rate hikes.
Resources for further research into the Federal Reserve and interest rate hikes:
U.S. Bureau of Economic Analysis (BEA): The BEA offers a wide range of economic data and statistics, including GDP, personal income and outlays, trade data, and industry-specific indicators. These data points can help you analyze the broader economic landscape and its relationship to investment strategies.
U.S. Bureau of Labor Statistics (BLS): The BLS provides data on employment, inflation, wages, productivity, and various other labor-related statistics. This data can be crucial in understanding labor market trends and their impact on investments.
Financial news outlets: Reputable financial news outlets such as Bloomberg, CNBC, Reuters, and The Wall Street Journal offer real-time market updates, expert analysis, and economic data releases. These sources can provide valuable insights into how changes to the Fed are being perceived by the financial community and investors.
Research reports and publications: Academic research papers, reports from financial institutions, and investment research firms can offer in-depth analysis and empirical evidence regarding the relationship between Fed changes and investment strategies. Websites like ResearchGate, SSRN, and research portals at top universities can be valuable sources for such publications.