Interest rate fluctuations can send ripple effects throughout the economy. While the recent interest rate raise is meant to support and stimulate current economic activity, it’s possible these effects could have an impact on stocks, bonds and other investments.
Interest rates 101
The Federal Reserve (Fed) has a dual mandate: to promote maximum employment and price stability. One of the ways they do this is through adjusting short-term interest rates.
If economic growth is lagging and unemployment is rising, the Fed can lower interest rates to make it cheaper to borrow, which should spur hiring, investing and consumer spending.
On the other hand, when the economy is growing quickly, the Fed may become concerned about inflation. In this case, the Fed can pump the breaks and raise interest rates to make borrowing more expensive and, in turn, dampen spending.
Reviewing the Fed's previous actions shows how these scenarios map out. For example, leading up to and during the financial crisis in 2007 and 2008, the Fed drastically lowered rates to help jump-start a flagging economy. Eight years later, rates were still hovering close to zero. As the economy strengthened, the Fed raised interest rates 9 times between 2015 and 2018.
More recently, the Fed cut interest rates 3 times in 2019 as the economy showed signs of slowing, twice in 2020 – to near zero again – to curb the economic effects of the coronavirus pandemic.
Given the recent ups and downs, it’s important to understand how interest rate changes can affect the components of your investment portfolio.
Interest rate impacts on bonds
Interest rates and bonds have an inverse relationship: When interest rates rise, bond prices fall, and vice versa. Newly issued bonds will have higher coupons after rates rise, making bonds with low coupons issued in the lower-rate environment worth less.
It’s helpful to understand the following three concepts regarding the bond and interest rate relationship.
Paper yields and paper losses: Imagine you purchased a bond for $1000, or par value. If the Fed raises the interest rate, this may decrease your bond’s market value to $900. In this case, the paper loss is $100 — but as the name implies, this loss is only on paper or may be the price you receive if you sell it. If you hold this bond to maturity, you should still receive 100 percent of its original par value, barring a default by the issuer.
Fluctuating interest rates and market rates: When interest rates fluctuate, the market rate of a bond fluctuates along with it. But not all bonds are affected equally: Bonds with shorter maturities may be less affected by interest rate fluctuations, while bonds with longer maturities will generally incur a greater paper loss.
Short-term changes vs. long-term outlooks: Short-term interest rate changes should not affect the long-term outlook for an investor with a long time horizon and an appropriate mix of stocks and bonds (balanced portfolio). Bond price decreases will likely be offset by bond price increases at a later date. Staying the course and diversifying can help to preserve your overall investment portfolio against the effects of changing interest rates in the long term.
Interest rate impacts on stocks
In contrast to bonds, interest rate changes do not directly affect the stock market. However, Fed actions can have trickle-down effects that, in some cases, impact stock prices.
When the Fed raises interest rates, banks increase their rates for consumer loans. In theory, this means there’s less money available for consumer spending. Also, increased rates for business loans can sometimes cause companies to halt expansions and hires. Reduced consumer and business spending can both lower the value of a company’s stock.
Still, there’s no guarantee that a rate hike will negatively impact stocks. Typically, rising interest rates occur during periods of economic strength. In this scenario, increased rates often coincide with a bull market. With a balance of stocks and bonds, your portfolio may be better positioned to maintain more stability despite an interest rate increase.
Interest rate impacts on other investments
In addition to stocks and bonds, consider how rate changes might affect other elements in your portfolio.
You may hold bank savings accounts and certificate of deposits (CDs) as a buffer for more volatile investments like stocks. An increase in the Fed’s interest rate may lead to an increase in the annual percentage yield (APY) on CDs and savings accounts. Therefore, CD and savings account rates generally are more favorable after an interest rate hike and less favorable after a cut.
Commodity prices may fall when interest rates rise, suggesting that an interest rate hike sometimes creates an unfavorable climate for these investments and vice versa.
If you have holdings in real estate, an interest rate hike can be detrimental, while a cut can be beneficial. Real estate prices are closely linked to interest rate markets, in part due to the cost of financing (mortgage rates) and in part due to some bond-like characteristics such as regular income payments. Like bonds, the relatively steady stream of income generated by real estate becomes less attractive as interest rates and coupons on newly issued bonds rise.
Because interest rate fluctuations can affect investments in different ways, there is no single action you should take when they change.
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Article initially appeared on usbank.com
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