Interest rates are on the move already in 2022 with the Federal Reserve recently announcing their plans for three rate hikes this year. So far this year, we’ve seen inflation significantly increase to record levels not seen since the late 1970s alongisde an ongoing global pandemic, historically low-interest rates, a dramatic oversupply of money from trillions of dollars of pandemic aid, and mass labor shortages from illness and people not wanting to work. Raising interest rates can help slow inflation down, and that’s exactly what the Fed plans to do. However, many people don’t realize that rate hikes also impact the economy in other ways beyond just tapering inflation. Many of these ripple effects play out in your everyday financial life, so it’s important to understand the impacts of rising interest rates so you can successfully navigate this environment.
The Impact on Inflation
Before we dive into the other impacts of rising interest rates, it’s important to understand why interest rate increases cause inflation to fall in the first place. In effect, it boils down to the simple relationship between interest rates and the costs of borrowing money.
When interest rates are low, the cost of taking on debt is cheap, so businesses and consumers are encouraged to borrow. When borrowing goes up, spending also goes up because it allows the borrower to spend money immediately as opposed to waiting to save the money for a purchase.
Following the basic economic principle of supply and demand, we know that if spending increases, demand also increases. With the increased demand, supply falls, and prices must increase to curb the demand. When prices increase, inflation increases.
On the contrary, when interest rates go up, the cost of taking on debt is more expensive, so fewer businesses and consumers will borrow. When borrowing goes down, spending also goes down. As a result of less spending, there’s less demand and more supply, so prices must fall to meet the demand. When prices fall, inflation falls as well.
The Impact on Spending and Purchasing Power
In low-interest rate environments, businesses and consumers pay less interest on the money they borrow, so they’re encouraged to borrow more. Borrowing more means more money to spend. More money to spend means greater purchasing power.
In rising interest rate environments, on the other hand, businesses and consumers pay more interest on the money they borrow, so they’re less incentivized to do so and will ultimately borrow less as a result. Borrowing less and paying more to borrow means less money to spend. Less money to spend means less purchasing power across the board.
The Impact on U.S. Stock Markets
When interest rates rise, both businesses and consumers cut back on spending.
When discretionary spending falls, businesses that are considered discretionary expenses may see their profits decline. For publicly-traded companies and the broader stock market, reduced profits that stem from a reduction in spending, typically mean reduced stock prices.
In low-interest rate environments, on the other hand, the increased borrowing leads to increased spending and increased profits, causing stock prices to rise. Additionally, we can’t count out the psychological aspects that are factored into the U.S. Stock markets.
In the era of the endless news cycle, any bout of negative news can cause panic and selling frenzies in the stock markets. If investors fear the value of their stock portfolio will go down, they often sell or reposition in the hopes of avoiding losses.
The Impact on the U.S. Bond Markets
Bonds are simply another form of debt, and governments and businesses use them to raise money to fund projects, growth, and expansion. Bond prices and interest rates share an inverse relationship with each other – when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. Why is this? Supply and demand.
When interest rates go up, newer bonds yield higher interest than the older bonds do, causing the older, lower-yielding bonds to become less attractive and their prices fall. Conversely, when interest rates go down, the older, higher-yielding bonds become more attractive, causing bond prices to rise.
Time is also a factor when considering interest rates and bond prices. Bonds can have either short- or long-term durations before they mature. The longer-term the duration of a bond, the more sensitive the bond’s price will be to changes in interest rates.
This is due to the fact that there’s a great probability that interest rates will rise within a longer time period than a shorter time period. In a rising interest rate environment, a longer-term bond will have more coupon payments left on it than a short-term bond, meaning the bond investor is going to be underpaid on that bond for a longer period of time. The difference in remaining payments on the lower-yielding bond will cause a greater decrease in the long-term bond’s price than it will in the short-term bond.
How to Successfully Navigate Rising Interest Rates
While some of what we’ve covered in this article might seem scary, the truth is that there are a number of ways you can reduce the impacts of rising interest rates on your current financial picture. Steps you can take to mitigate the effects of rising interest rates can include:
- Reduce the duration of bonds you’re holding. In addition to buying shorter-term bonds, you can also use debt instruments like floating-rate debt and Treasury Inflation-Protected Securities (TIPS), where their adjustable interest rates are less sensitive to rising interest rates than other fixed-rate debt instruments.
- Look to specific sectors for your stock portfolio. Some sectors of the economy actually benefit from increases in interest rates. Financial companies and other money lenders, for example, tend to realize higher profits in higher interest rate environments. Other sectors like raw materials, often see prices remain stable or even go down when interest rates rise. Additionally, companies that have lots of cash on their balance sheets can weather rising interest rate environments due to their strong financial positions.
- Manage your debt wisely. If you have any adjustable-rate debt, such as credit cards, a line of credit or an adjustable-rate mortgage, an increase in the federal funds rate is going to cause an increase in the interest you’re paying on that debt. Now’s a good time to either get that debt paid off or consider consolidating/refinancing any adjustable-rate debt to a fixed-rate loan. Also, be careful taking on any new debt so as to not have rising interest rates adversely affect you.
The Bottom Line
There are both positive and negative impacts on the economy from rising interest rates. Understanding what these impacts are and how they affect you can help you avoid common behavioral pitfalls while allowing you to take advantage of the opportunities to successfully and confidently navigate this environment. However, if you’re still confused, have questions, or want professional assistance making the right decisions, you can click here –> to schedule a free consultation today with one of our expert advisors to see how we can help you achieve success on your financial journey.
Securities and investment advisory services offered through Calton & Associates, Inc. member FINRA and SIPC, a Registered Investment Adviser. Forefront Wealth Partners is not owned or controlled by Calton & Associates, Inc.