As vaccines take hold and the economy begins to return to normal, the Fed, at some point will raise interest rates. We look a few months to a year down the line at your investments when interest rates rise.
Interest Rates and the Stock Market
Investors worry about interest rates for good reasons. When the Federal Open Market Committee of the US Federal Reserve raises the target interest rate for federal funds, that action raises rates across the entire economy. While the full effect on the US economy will typically take a year to settle in, the stock market anticipates these effects and reacts immediately. Interest is what companies pay to borrow money and thus the effects of higher rates are greater on highly leveraged enterprises with large debt loads.
High Interest Rates and the Economy
Overall, when interest rates go too high, companies borrow less and spend less. This tends to slow the economy and the higher interest rates go the more pronounced the effect is. When the economy enters an inflationary trend, the Fed will raise rates to “cool off” the economy. And, when the economy slows, the Fed will lower rates to help stimulate spending and the economy. Because of the severity of the Financial Crisis, rates stayed down for years. And, with the Covid-19 crisis and a projected k-shaped recovery, they are likely to stay down again until the economy starts to revive.
Low Interest Rates and the Bull Market
Interest rates went down with the 2008-9 financial crisis and stayed at near to zero until 2015. They rose 2.4% by the end of 2018 and then fell to near zero again with the Covid-19 pandemic crisis. With bonds paying little or no interest, investors put their money in the stock market driving prices up.
What Happens to the Market When Interest Rates Go Up This Time?
The stock market has gone up after the initial shock of the Covid-19 crisis despite high unemployment and a weak economy across many sectors. Companies have gotten used to borrowing at extremely low interest rates. When the economy starts to recover as vaccinations start to overcome the virus, the Fed is likely to raise interest rates a bit at a time. What happens to your investments when interest rates rise?
Companies with no cash reserves and large debts will be in trouble. Companies that have leveraged their stock price growth with expectations of huge gains eventually may find themselves cut off from funding and suffer financial collapses. This could include promising ventures like Tesla whose stock went up more than four-fold this year as it saw its first profitable year in 18 years of existence. However, much of its profit came from the sale of emission credits to other automakers!
Banks will do well as interest rates go up, as they always do unless higher rates drive the economy back down.
Normally, during a recession, stocks are down almost across the board. That is not the case this time and that confuses the issue a bit. As the virus subsides and the economy improves, stocks in the travel and hospitality sectors will start to recover. They are not over-priced and will have some room to run before higher interest rates hurt them. But, the current high-flyers may experience long-awaited corrections.
Worst-hit Stocks When Interest Rates Go Up
The worst-hit will probably be those investments that have been prone to speculation such as those involved in the recent retail investor frenzy and perhaps bitcoin as well. When rates go up the dollar will get stronger on the Forex markets and interest-bearing investments will return to favor.
As always, over the long term, companies with the ability to keep making profits through good times and bad will prosper. Those who purchase such investments when prices are low will do especially well and those who try to get the last bit of profit out of the bull market before higher interest rates force a correction will get hurt.
Your Investments When Interest Rates Rise – Slideshare Version