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Narrator: The Federal Reserve, or "Fed," is the central bank of the United States. Its goal is to keep the U.S. economy stable in two ways: maximizing employment and stabilizing inflation.
One of the Fed's primary tools is decreasing or increasing the federal funds rate, which is the rate banks charge each other for overnight loans. It is considered the base lending rate and can impact interest rates throughout the economy. If the economy has grown rapidly and fears of inflation emerge, the Fed has typically responded by increasing interest rates.
One of the Fed's primary tools is decreasing or increasing the federal funds rate, which is the rate banks charge each other for overnight loans. It is considered the base lending rate and can impact interest rates throughout the economy. If the economy has grown rapidly and fears of inflation emerge, the Fed has typically responded by increasing interest rates.
Inflation is the rate of the rise in the cost of goods and services. Basically, it's how much your money loses value over time. While inflation typically goes hand in hand with economic growth, too much inflation can hurt the economy and lead to a recession.
For example, unprecedented levels of stimulus and COVID-19 supply constraints fueled a 7% rise in inflation during 2021, the fastest increase since 1982. Many economists fear unchecked inflation could turn an economic boom into a bust. In response, the Fed began raising rates in 2022. Here's how a rate hike works.
When the Fed increases the federal funds rate, it typically pushes interest rates higher overall, which makes it more expensive for businesses and individuals to borrow. The higher rates also promote saving. The goal is to reduce the spending that is driving up prices and overheating the economy. Raising rates enough to slow inflation but not dampen the economy so much that it causes a recession is a tricky balance.
Looking at a history of changes in the federal funds rate, we can see that there's often a series of rate hikes ahead of a recession, but not every series of hikes leads to a recession.
So, that's the big picture of how and why the Fed may hike rates. Let's look at what impact it may have on your investments. It can take time for the effects of rate hikes to work their way through the economy, but financial markets, which are forward-looking, may respond more quickly. A common misconception is that rising rates will cause a bear market. This isn't necessarily true. The relationship between stocks and interest rates is complicated. A BlackRock study found that from 1995 through 2020 when the 10-year Treasury yield rose more than half a percentage point, the S&P 500® rose on average 3.2% over the following three months. However, in 2022, the market did fall as the Fed was raising rates.
Rising rates can impact individual stocks too. Interest rates like the 10-year Treasury yield are used when calculating stock valuations using the discounted cash flow model, and the impact could differ across the market.
For example, higher interest rates may hurt growth stocks more than value stocks. The high valuation of growth stocks tends to be based on expectations of future profits, but rising rates can decrease the value of those expected profits, taking growth stock prices with them.
For example, toward the end of 2021, the Fed started signaling that it was concerned with inflation and would likely start hiking rates. Even before the Fed started raising rates in March of 2022, the S&P 500 Pure Value index started outperforming the S&P 500 Pure Growth index. Throughout much of 2022 as the Fed continued to raise rates, the value index continued to outperform the growth index.
Rate hikes can affect specific stock sectors in different ways. For example, financial stocks, and more specifically bank stocks, tend to perform better when interest rates rise because it allows them to charge borrowers more. Notice how the PHLX Bank Index tends to move with the 10-year yield. Of course, past performance doesn't guarantee future performance.
While rising interest rates aren't necessarily bad for stocks, they can be negative for bond prices. Bond yields and bond prices move in the opposite direction. This chart shows how a 1% rise in rates could impact Treasury prices. The longer the maturity, the greater the effect a rise in interest rates will have.
Because rising rates are so tough on bonds, many investors may change their allocation in anticipation of rising rates by selling bonds and buying stocks or going to cash. If the flow of funds goes from bonds to stocks, stocks could go higher.
Keep in mind, it's not just the fact that rates are rising, but the speed at which rates rise that can influence your investments.
In 1979, Fed Chairman Paul Volcker aggressively raised the federal funds rate several times to stave off double-digit inflation, which prompted a bear market from November of 1980 to July of 1982.
In subsequent decades the Fed hiked rates at a slower pace, typically a quarter point at a time. However, in 2022, the Fed was much more aggressive in its rate hikes because it didn't want inflation to get entrenched like it did in the '70s. While it started with a quarter-point hike, it went to half-point hikes and then a series of three-quarter-point hikes.
Whenever the Fed raises rates, investors should prepare for potential volatility as the market adjusts to a new environment. Areas of the market with high leverage or low liquidity may react the most. But rate hikes can eventually be an opportunity for investors looking for higher yields from lower-risk investments like bonds and cash. Staying focused on your long-term goals can help you ride out rate hikes and cuts and any market swings that follow.
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