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Interest rates are a fundamental aspect of the global economy, and the aggressive rise in interest rates over the past 18 months has had a profound impact on investors. In this article, we will explore the impact of rising interest rates and how to navigate this new environment.
NOTE: THIS IS PART TWO OF A THREE-PART SERIES. WE WILL ADDRESS THE BROADER IMPACT OF RISING INTEREST RATES ON THE ECONOMY IN PART 3.
Interest rates are set by central banks and they play a crucial role in influencing borrowing costs and inflation.
While rising rates can have a significant impact on retirement savings, they don’t have the same impact on all asset classes:
· Bonds - One of the most immediate effects of rising interest rates is the negative impact on bond prices and an increase in bond market volatility. When interest rates climb, the fixed interest payments on existing bonds become less attractive compared to new bonds offering higher rates. As a result, the prices of existing bonds fall. This leads to capital losses for bondholders who sell their bonds before maturity. Investors who choose to hold their bonds until maturity will likely receive their coupon payments and the return of their principal, but they miss out on the opportunity to reinvest at higher interest rates.
· Stocks - Rising interest rates can also negatively impact the stock market. Higher interest rates can benefit stocks in the long-term, but in the short-term they tend to increase the cost of borrowing for businesses, which can result in reduced corporate earnings and slower economic growth. And this can lead to lower stock prices.
· Real Assets - Rising interest rates can also be seen as a response to increasing inflation. Inflation erodes the purchasing power of money, and this has the potential to make real assets like commodities more attractive. In an environment of rising interest rates, real assets may perform well, offering a potential store of value. Investors may consider adjusting a portion of their portfolios to such assets as a hedge against inflation.
· Cash and Short-Term Investments - One of the simplest ways to adapt to rising interest rates is to increase allocations to cash and short-term investments. As interest rates climb, the yields on savings accounts, certificates of deposit, and short-term government securities improve. This can provide investors with a safer and more attractive option for parking their funds while awaiting better investment opportunities. Sitting in a 5% yielding money market account in 2023 has much lower opportunity cost than it had back in 2021, when money market accounts were yielding less than a half percent of interest each year.
5 Year Treasury Bond Yield
Source: fred.stlouis.org
AGG ETF
Source: Interactive Brokers Trader Workstation
The Agg ETF is a BlackRock exchange traded fund that attempts to provide broad exposure to U.S. investment-grade bonds. Notice the matching time frames, when bond yields rise, bond prices fall.
Diversification and Risk Management
Diversification is a timeless strategy for mitigating risk in a portfolio. When interest rates rise, it is especially important to maintain a well-diversified investment approach. Diversification across asset classes, geographies, and investment styles can help spread risk and ensure that a portfolio is better positioned to withstand market fluctuations.
When Everything Hits the Fan
While different assets classes may respond differently to rising interest rates, the more significant risk lies in the potential impact on investor appetite for riskier assets. If interest rates rise too quickly and bonds prices drop aggressively, or the stock market drops by 20%, investors can get scared and choose to move their assets into cash or the safety of short-term treasury bills. When this “risk-off” environment happens, there are few safe places to hide, as most of the riskier asset classes will get hit by the same storm.
Yes, diversification can help on a longer-term basis, but it rarely does a good job at holding off losses on the short-term - especially when markets are in panic-mode. For example: the safer asset classes still posted significant losses during the Global Financial Crisis in 2008.
This is where investors need to have a clear picture of the level of risk they are taking, regardless of what happens to the stock market. In these environments, it is important for investors to not hit the panic button, but instead hold onto a long-term view and remain disciplined.
Conclusion
Rising interest rates are a natural part of the economic cycle, and investors must adapt to these changes to protect their portfolios and pursue their financial goals. By understanding the shifting impact of rising interest rates on different asset classes and employing appropriate strategies, investors can navigate these challenges successfully over the entire economic cycle.
The key is to stay informed, maintain a diversified portfolio, and periodically review and adjust investment strategies to reflect changing economic conditions. In doing so, investors can minimize the negative effects of rising interest rates and continue to work toward their financial objectives.
This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.
LEGAL, INVESTMENT, AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.
Copyright 2023. Monotelo Advisors Inc. All Rights Reserved
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