On January 11, 2022, Federal Reserve Chair Jerome Powell testified before Congress
that the Fed planned to raise the federal funds rate in the coming year to help combat rising
inflation. What Powell didn’t specify was exactly when and how much rates will rise.
Many people fear that raising rates causes the stock market to fall. So, let’s discuss how
changing rates may affect your portfolio. The Fed’s goal is to keep the U.S.
economy stable in two ways: maximizing employment and stabilizing inflation.
One of the Fed’s primary tools is 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, the Fed has typically responded 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 hurt the economy and lead to a recession.
For example, unprecedented levels of stimulus and COVID-19 supply constraints fueled a 7%
rise 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’d raise rates in 2022. Here’s how a rate hike works.
The Fed increases the federal funds rate, which is the rate banks use when they lend to one another.
This typically pushes interest rates higher overall, which
makes it more expensive for businesses and individuals to borrow and promotes saving.
The goal is to reduce the spending that is driving up prices and overheating the economy. 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 Fed’s 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 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 rallied.
Let’s look at specific stock sectors as well. From 2002 through 2020,
real estate was the best-performing sector when inflation was rising. This graph shows
that 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 these conditions. Of course, 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. Notice how the PHLX Bank
Index tends to move with the 10-year yield. 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. This chart shows how a 1% rise in rates could impact Treasury prices.
The longer the maturity, the greater the effect a rise in 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. The 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 threw 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. Some 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 and any market swings that follow.