The Federal Reserve has a dual-mandate to promote maximum employment and stable prices. Given these policy goals, it is not surprising the Fed went forward with an initial 0.25% hike yesterday as unemployment is sitting at just 3.8% but inflation has been running hot with the most recent reading at 7.9%. Given the tight job market and desire to bring inflation down, they also predicted six more interest rate hikes this year.
This is the first interest rate hike since 2018, so now is a great time to revisit what interest rate hikes mean for your investment portfolio. We have been fielding some questions about this topic and have three main points to highlight:
A common concern we hear is that the Fed is taking away the punch bowl and increasing rates are going to be bad news for stocks. It is true that higher rates are meant to act as a break on the economy, but that doesn’t necessarily mean negative stock market returns. Yesterday, stocks rose sharply despite (maybe because of?) the interest rate announcement and, historically, stocks do well following interest rate hikes.
The chart above from Reuters shows that stocks perform basically in line with their historical average during rate hike cycles. This isn’t surprising as interest rates aren’t the causal link to stock market prices. In fact, the correlation is likely the other way around. The Fed typically is not raising rates when the economy is in bad shape. The Fed is responding to the economy when it adjusts rates and the strength of the economy is what drives stock prices. This creates a scenario where stocks tend to rise when the Fed raises interest rates, but the stock market rise is not in response to the Fed’s interest rate decision but rather the strength of the economy.
Bond prices and interest rates are inversely correlated, so a rise in interest rates results in a decline in bond prices. This is a headwind in the short-term for fixed income, but there is a silver lining. The yield on bonds you buy in the future will be higher than they are now. Many have bemoaned the low yield from investment grade bonds today, but this is a step in the right direction for those looking to get more yield from bonds.
Between interest rates and inflation, the bigger risk we face right now is inflation as higher prices eat into the purchasing power of portfolios. The relationship between interest rates and investment performance is complicated, but the relationship between the purchasing power of our money and inflation is not.
With inflation running persistently above the Fed’s 2% target, actions that result in lower inflation are likely more valuable to investors and consumers than any direct impacts from the actual rate hike itself. People who lived through the 1970’s know all too well the negative impact high inflation can have. The Fed has plenty of room to use its policy tools to combat inflation, though, and it will be positive for investors if the Fed is successful as that will keep at bay the silent drag inflation has on portfolios.
This initial hike is likely just the first in a number of hikes to expect over the next few years. The Fed was taking steps to normalize policy before the COVID-crisis forced them back to their ultra-accommodative stance to fight the recession. This is a return to that normalization path. It is important to keep in mind that the Fed does not make these decisions in a vacuum and there is broad agreement on the FOMC committee that the economy is strong enough to handle higher rates. It is not clear that rising rates have any direct impact on stocks and, though there is likely to be some negative price action initially for bonds, future coupon payments will be higher. Ultimately, the Fed gets a lot of attention for its interest rate policy but there is not any reason to alter your asset allocation mix in response.