The Federal Reserve recently indicated that they will raise their benchmark Federal Funds rate by 25 basis points for the first time since 2018. They indicated that this will be the first of several rate hikes during the year. In addition, they’ve indicated that they will be unwinding their balance sheet as well.
Let’s take a look at what these moves could mean for investor’s portfolios.
Overview of interest rates
Interest rates impact the amount of interest paid by issuers of bonds both in the corporate sector and by the Treasury. The direction of interest rates also impacts the interest that both individual borrowers and corporations will have to pay for loans. In the case of individuals an interest rate increase will make home mortgages and car loans more expensive.
There are a number of factors that impact Fed decisions about interest rates. Over the past couple of years, the Fed has kept interest rates low to combat the economic impact of the pandemic. As the economy has recovered and strengthened, we’ve seen an uptick in inflation caused by a number of factors. The Fed’s latest moves are designed to help keep inflation in check.
The Fed Funds rate is the rate at which the Fed suggests that member banks charge other member banks to borrow their excess reserves on an overnight basis.
Interest rates don’t necessarily impact the stock market directly, but the prospect of higher interest rates can have an impact on companies who typically borrow to finance their operations and on banks and other financial services companies. Higher rates can serve to depress the earnings of industrial and consumer companies who borrow to finance their operations.
How interest rates impact your portfolio
Higher interest rates impact investors in different ways. For investors in bonds or bond mutual funds and ETFs, higher interest rates will drive down the value of their bond holdings. For individual bonds this will lower their price in the secondary market. Newly issued bonds will generally carry a higher yield when interest rates rise. Longer duration bonds and bond funds will feel the greatest impact as these are the bonds that will feel the greatest impact in terms of price declines from rising interest rates.
Rising interest rates don’t impact stocks directly, but higher rates can have an impact on stocks nonetheless. First, higher interest rates can slow down the economy as the cost of borrowing rises. Higher interest costs can impact the bottom line of companies whose balance sheet includes a fair amount of debt.
Rising rates can impact consumer spending. Mortgages become more expensive impacting the housing market and related businesses such as home builders and companies that sell goods or services in the home improvement space. Consumer purchasing can be impacted as consumers see interest costs for mortgages, credit cards and personal loans increase. This reduced spending can impact stocks across a number of industry sectors.
The real estate sector is likely to feel the impact of rising rates. Financing commercial properties can be more expensive, this will impact real estate investments such publicly traded REITS. Rising rates will impact the bottom line of firms in this sector.
Current interest rate hikes
Arthur Bass, Managing Director of Wedbush Securities, had a number of thoughts on the Fed’s latest moves on interest rates.
Bass says, “There was a dramatic move in interest rates over the past week as markets adjusted to a more aggressive Fed tightening path. This resulted from the economic projections and anticipated tightening path presented at the FOMC meeting, and Fed Chairman Powell’s comments at both the press conference and again this Monday.”
He says, “Markets are now pricing 45bp of tightening at the May 4 FOMC meeting, 85bp by the June 15 meeting, and 120bp by the July 27 meeting. We expect the yield curve will invert as the Fed continues its tightening program.”.
Bass adds, “Markets are currently pricing a peak in Fed Funds around 2.75% to be realized in the fourth quarter of 2023. This would be a very short tightening period by historical standards. The Fed’s tightening campaign was cut short in 2018/2019 by a significant correction in risk assets. Fed Funds peaked at 2.5% in 2018, while CPI was 1.9%. CPI is currently 7.9%, and 6.4% ex food and energy. The question facing the markets is how aggressive the Fed will continue to be as the economy corrects.”
What should investors do when interest rates go up?
For long-term investors rising interest rates are part of the picture over time. They should not have to make major portfolio shifts.
That said, investors may want to review the fixed income portion of their portfolios. They may want to consider reducing the duration of their fixed income holdings. Additionally, as rates increase, they may want to put some new money to work in bonds with higher yields.
They will also want to review their equity holdings to determine if any equities stand to be impacted positively or negatively by rising rates and adjust accordingly if appropriate in the context of their overall investment strategy.
This is a good time to discuss the impact of rising interest rates with your Wedbush Securities advisor, feel free to reach out to them.
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