Last Updated: June 29, 2022
After falling behind the curve with its transitory message, the Fed Reserve has gone full throttle against rising inflation.
The latest CPI data pegs inflation at 8.6%, the highest level in 40 years. Prices of groceries, gas, housing, and transportation have gone through the roof.
While consumers groan, the effects of the monetary policy are certain to inflict further pain in the pockets of many. The Fed Reserve Chairman, Jerome Powell, has scheduled more rate hikes this year. Observers expect those hikes to continue into the following year.
The Fed usually only raises rates by a small percentage (basis) points each time. However, those little drops cause dramatic moves across financial markets and asset classes.
The effects of the last tranche of rate hikes are already causing ripple effects. The S&P 500 and NASDAQ have both dipped into bear market territory. 10-year Treasury yield has risen above the 3% mark, its highest since 2018. The US Dollar is having its longest streak of weekly losses in over 10 years.
If you’re planning on taking out a new home mortgage loan, credit card, or investing in stocks or cryptos, you may want to keep in mind that rates are higher now and this has affected not only allocation of capital, but investor sentiment also.
Knowing what to expect can assist you in determining what and when to invest. In this article, we examine how rising interest rates can affect money market accounts, equities, bonds, and commodities.
If you’re in a high-interest non-investment account, you would be benefiting from rising interest rates without having to do anything.
As the Fed increases benchmark interest rates, banks and other financial services providers tend to increase the rates they offer on high-interest savings accounts, money market accounts, and certificates of deposit (CDs).
Although these rates are still unlikely to match what you’d get from investing in the stock market long term, they can be a viable source of cash flow and asset protection. They can make these financial products a more attractive place to park your money.
If you’re already in a high-interest non-investment account, many banks will keep raising your rate without you having to do anything. If you’re not, this could be a good time to start looking around for an institution that’ll put more money in your pocket.
Should you already have money in a CD, rising rates won’t do much for you until the term ends, since you’re probably locked into what you signed up for. Alternatively, you can consider CD laddering to increase your income during this period.
When you purchase a bond, you loan money to a company or the government for a set amount of time and receive a fixed return in exchange.
When interest rates rise, bond yields—or the return you make on investing in a bond—rise as well.
Bond yields have been on the rise even before the Fed hiked interest rates. The 10-year Treasury note, which investors considered to be the barometer to gauge the bond market, is above 3%, its highest level since 2018.
Unlike some investments, interest rates don’t have a single, defined impact on the stock market.
Rising interest rates have varied effects on stocks, depending on the sector that they are in. For high-growth multiple stocks whose price is based on future earnings, rising interest rates are bad news.
On the other hand, value stocks, especially dividend aristocrats, usually fare well during rising interest rates. Stocks in the financial, utility, and consumer staples sectors do well during this period of rate hikes.
But in general, a rise in interest rate is not good for stock markets. This is because stocks are a more risky asset class, compared to bonds where the return is guaranteed because it has the backing of the government.
As such, institutional investors prefer to allocate capital to areas where returns are guaranteed rather than investing in risky assets like stocks where you could get losses.
Similarly, because consumers are paying higher interest rates on existing bills, they have less money left over to spend on other goods and services. Reduced spending affects companies’ revenues and profits, which can have a ripple effect throughout the stock market.
Companies also find it more expensive to borrow when interest rates rise. They may borrow less or have less money left over to invest in their business, or disburse as dividends to shareholders. This would also drive revenues lower, which would affect investor sentiment and price action towards the stock in a negative way.
Just like stocks, interest rates usually have an inverse relationship with commodities prices than they do to the stock market. When interest rates rise, commodities prices usually fall and vice versa. This is because of the cost of carry—the costs associated with holding inventory.
When interest rates rise, it is more expensive for the companies that buy commodities to stockpile them and store them for long periods. Likewise, when it's cheap to store inventory, businesses have more demand to stock up, which pushes costs higher.
As a result, companies will buy more commodities as they need them and lower demand will fuel lower prices.
Though the timeframe may be too short to formulate a thesis on how interest rates affect cryptocurrencies, the reaction of the crypto market can perhaps provide an inkling of what investors can expect.
Cryptocurrencies are regarded as a high-risk asset class. When rates are rising, investors tend to be risk-averse.
As evidenced by current price action, higher interest rates take the shine off crypto investments, because they give savers the opportunity to secure more attractive returns in a lower-risk way. As such the prices of cryptocurrencies would decline until investors discover their appetite for risk (assets).
Inflation tends to devalue a currency since inflation can be equated with a decrease in a money's buying power.
As a result, countries experiencing high inflation tend to also see their currencies weaken relative to other currencies.
However, because central banks exist to combat inflation, a rise in inflation leads to an increase in benchmark interest rates which inadvertently strengthens the currency. Currencies surrounded by lower interest rates are more likely to weaken over the longer term.
Rising interest rates affect assets in different ways.
As an investor, it is important that you have an understanding of how different investments react to rate hikes. This is the basis for knowing how best to deploy your capital and avoid, if not reduce, potential losses to your portfolio.
Being able to navigate market cycles is the hallmark of a successful investor. However, your success is anchored on an understanding of the unique characteristics of each asset and how to best trade them, and when.
March 23, 2023