The outbreak and spread of COVID-19 in the United States at the beginning of 2020 put a strain on the economy and created a financial shock throughout the country, as well as worldwide. As the US economy slowly begins to get back on track, the Federal Reserve interest rates currently stand near zero percent. Interest rates are the percentage charged for the cost of money borrowed at a certain period of time. If we take a further look at this, we can see that interest rates haven’t been this low in over 60 years. The Federal Reserve announced that they are aiming to keep interest rates between 0% to 0.25% for now. That’s extremely low! However, the Feds may be planning on raising interest rates when inflation, or the price of money, exceeds or remains at 2% (federalreserve.gov). So how does rising interest rates affect you and your portfolio?
Let’s start with some background. One of the main responsibilities of The Federal Reserve is to ensure that the economy is growing steadily. The Federal Reserve’s main focus is to advance economic conditions to ensure price stability and supportable employment for people (chicagofed.org). This is where interest rates come into play. If the economy is doing poorly and unemployment increases, the Feds may decrease interest rates. So if we look at the economy today, many people lost their jobs due to COVID-19, and therefore increased the levels of unemployment and decreased the amount of money people had available to spend freely. Low interest rates allow businesses and consumers to borrow and take out cheaper loans in hopes of increasing spending and adding more money into the economy. The goal of lowering interest rates is to encourage people to spend more money to help stimulate the economy and keep it from collapsing. If the economy is growing too rapidly, meaning people are spending too much, the Federal Reserve may increase interest rates. This makes it more expensive to spend and take out loans, essentially putting brakes on the economy and slowing it down.
Today, interest rates are at a record low, as the Feds may be trying to push the economy back up after the financial disaster we experienced in the past year. However, these low interest rates are not permanent. In the coming years, we might see the Federal Reserve begin to increase interest rates as soon as more money is pumped back into the economy. So let’s circle back to the question at hand. What are the implications of rising interest rates on your portfolio? Looking at a diverse portfolio that may contain, for example, bonds, stocks, and cash investments, we can identify that high interest rates mostly affect bonds and indirectly affect the stock market.
Bonds
Bonds are directly affected by interest rates. Why is that? Bonds and interest rates have an inverse relationship, meaning if one goes up, the other goes down, and vice versa. Rising interest rates are going to have a negative effect on bonds, decreasing the value of its price and impacting bond yields, specifically for long-term bonds.
Stock Market
The stock market is not directly impacted by rising rates. Instead, the rise of interest rates causes a trickle down effect that indirectly causes the market to shift. Let’s take a deeper look at this. As mentioned before, when interest rates are increased, the cost of borrowing and spending dramatically increases. Businesses are less likely to borrow or take out loans, and in turn, are less motivated to continue growing during that time period. Consumers have less disposable income to spend and, overall, reduce borrowing and loans. With both of these constraints from businesses and consumers, the flow of cash entering the company decreases dramatically and negatively affects earnings and stock prices.
The Final Word
Interest rates are continuously fluctuating as a way to control inflation. It’s important to be aware of the effects of interest rates and be prepared for any possible implications. Working with an advisor and being able to manage your portfolio during rising rates may help alleviate any negative repercussions.