Many investors know that interest rates have a big impact on their debt. After all, when interest rates rise, the cost of borrowing goes up. But did you know that rates can also affect your investments? Here's how to invest when interest rates are rising.
As an investor, there are a number of factors that you should consider when you're developing your investment strategy. Interest rates should be one of those considerations when crafting or readjusting your portfolio. Not only do they affect the cost of borrowing, but they also have a big impact on how your investments perform. By using the guide provided below, investing with interest rates in mind can help you make better-informed investment decisions.
When might you trade on interest rates?
- To back your judgment on future changes in short-term interest rates
- To hedge against other investments affected by interest rates, such as mortgage repayments
What is ‘the interest rate’?
The interest rate is the overall lending rate in a country, which ties into the overall rate worldwide. A country’s interest rate is either the stipulated amount at which commercial banks borrow from one another or the rate at which commercial banks may borrow from the central bank.
The most important interest rate is set by a central bank like the Federal Reserve (FED), which affects all other interest rates in an economy. Central banks of very influential economies such as the United States, EU, China, Japan, and the UK will affect developing countries’ rates too.
Because interest rates play a central role in spending, central banks use them to influence the entire economy as they have a ‘trickle down’ effect.
If the rate is hiked, the increased cost of borrowing by banks is passed onto businesses and consumers who then pay increased interest rates on loans, which also constrains spending. If the interest rate is reduced, loans become cheaper to pay back, and spending increases.
The interest rate is used as a tool to help control inflation and stimulate economic growth during periods of stagnation.
How do interest rates affect the markets?
Interest rates directly affect the exchange value in the forex market and bond market because the rates’ movements directly impact demand for a currency and yields. In contrast to bonds and currencies, interest rate changes do not directly affect the stock market. However, central banks’ actions can have trickle-down effects that, in some cases, impact stock prices.
This is because interest rates are a measure of the rate of return on certain investments and savings. Due to the relative attractiveness of the interest rate, investors may want to move capital into or out of a country and asset class, which impacts the supply and demand for a specific security.
It’s important to remember that the effect of interest rate changes on financial markets is never guaranteed. It also doesn’t happen in isolation, but rather depends on several factors such as the perception of an economy’s future strength and stability.
As prices and rates depend on the supply and demand of a particular security, all factors that impact either of these will affect the value of the tradeable financial asset. You should have this top of mind at all times when you conduct your analysis of the markets.
The Impact on Bonds
The federal funds rate, which is the interest rate commercial banks charge one another to borrow money for a relatively short period of time—typically overnight—is determined by the Federal Reserve. Generally speaking, when the federal funds rate increases, so do interest rates for other bonds. Moreover, bond prices often decline when interest rates rise.
Not every situation has the same impact. The coupon and maturity date of a bond, as well as other variables, affect how sensitive it is to changes in interest rates. Bonds with extended maturities and low coupons typically react to changes in interest rates more quickly.
A rise in interest rates may force bondholders wishing to sell their bonds before they mature to provide a discount from face value in order to compete with newly issued, higher-yielding notes. Rising interest rates, however, might not be as much of an issue if you buy and retain individual bonds until maturity because, assuming the issuer doesn't default, you'll get your entire principal back at that time.
Rising interest rates could make some fixed-income assets more enticing for investors whose main goal is to generate income. Bonds are typically more appealing than risky assets like equities due to higher yields.
The Impact on Stocks
All else equal, rising rates tend to weigh on stock valuations, as they can drag on corporate profits and growth potential. This effect often plays out in anticipation of Fed action. As investors saw during the first half of the year, stocks fell from their peaks as the Fed was just beginning its rate hike campaign. Still, different areas of the market may react differently:
Growth stocks: Pricey growth stocks, whose valuations are based on expected future returns, may have their wings clipped when interest rates are heading higher. The threshold for future profits required to support current stock values is immediately raised when rates rise. Dividend stocks: Dividend payers may need to raise their yield to compete as bonds may now offer investors higher coupon rates and lower risk. Rising interest rates can also hinder corporate profitability and make dividend payments more difficult, especially for businesses with high debt loads. Financials: One industry where higher interest rates may be advantageous is finance since lenders may potentially be able to make more money off of loans. In the past, during periods of rising rates, banks, and financial institutions have outperformed the S&P 500.
The Impact on Currencies
Interest rates have an impact on currency exchange values because changes in interest rates have a direct impact on demand for a given currency.
This is due to the fact that interest rates serve as a gauge for the rate of return on particular savings and investments. Investors may wish to transfer money into or out of a country due to the relative attractiveness of the interest rate, which affects the supply and demand for a certain currency.
The demand for forex when interest rates increase
You can get a better rate of return on savings deposits, lending, or government and corporate bonds when interest rates are raised.
Theoretically, money will transfer from currencies in nations with unfavorable investment opportunities to those with more promising ones, which will have a beneficial effect on the exchange rate. The preferred currency will see an increase in demand as a result of the money movement, while the less popular currencies will see a decline. The exchange rate will therefore suffer as a result.
The demand for forex when interest rates decrease
Investors can anticipate a lower rate of return on savings deposits, loans, or government and corporate bonds when interest rates decline.
Again, potentially, investors might locate more advantageous chances elsewhere. As a result of investment capital flows shifting to more alluring investment locations, the demand for that currency will decline. The exchange rate in that nation would decline as a result. Additionally, it would boost the native currency's supply on the forex market, bringing down the exchange rate even more.
Interest rate impacts on other investments
In addition to stocks and bonds, consider how rate changes might affect other elements in your portfolio.
As a safety net for riskier investments like equities, you might keep bank savings accounts and certificates of deposits (CDs) in your possession. The annual percentage yield (APY) on certificates of deposit (CDs) and savings accounts may rise as a result of an increase in the Fed's interest rate. As a result, rates on CDs and savings accounts are often better following an increase in interest rates and worse after a decrease.
Commodity prices may decline when interest rates increase, indicating that a rise in interest rates can occasionally create an adverse environment for these investments. Interest rates and commodity prices have an inverse relationship because the costs associated with holding inventory decrease in low-interest-rate environments. When it's cheap to store inventory, businesses have more demand to stock up, which pushes costs higher.
An increase in interest rates can be bad if you own real estate, while a decrease can be good. Real estate values are tightly correlated with interest rate markets, in part because mortgage rates are expensive to finance and in part because some properties of real estate resemble bonds, such as regular income payments. Similar to bonds, real estate's relatively consistent revenue stream loses appeal as interest rates and coupon payments on recently issued bonds climb.
How to Invest for Rising Interest Rates
Interest rates should be a factor that investors should consider when crafting or readjusting their portfolios. Here's how investors can benefit from rising interest rates according to analysts.
1. Invest in Banks and Brokerage Stocks
Interest is a source of revenue for banks and brokerage houses. As a result, they can earn more when interest rates are higher because credit is less easily accessible at those times. Customers are prepared to pay more to borrow as a result. Financial services companies like banks and brokerages have witnessed a boost in interest income and operating profit margins when the Fed has raised interest rates in the past.
On the other hand, when interest rates are low, borrowers typically have more money in their pockets. They thus frequently borrow more money and make larger purchases during this time. As a result, banks can profit from the interest they generate in greater quantities. Banks are nevertheless lucrative even when interest rates are low thanks to the fees, commissions, and service charges they collect from their clients.
Important: Note that if interest rates rise too high, it can start to hurt bank profits as demand from borrowers for new loans suffers and refinancing drops.
2. Invest in Technology, Health Care Stocks
Many investors like dividend-paying companies because they distribute a percentage of their profits to shareholders. Nevertheless, you might want to go elsewhere if you're seeking a long-term growth strategy with interest rates in mind.
Instead of giving out profits as dividends, businesses in the technology and healthcare sectors are more likely to retain larger sums of money as retained earnings to spend on new business prospects. According to historical data, the healthcare and technology sectors often outperformed the USA 500 Index during times of rising interest rates.
3. Invest in Cash-Rich Companies
Companies with lots of cash make more money off their cash reserves when interest rates rise. Investors might search for businesses with low debt-to-equity (D/E) ratios or businesses with high cash ratios as a percentage of book value. A chance is to invest in cash-rich companies like Berkshire Hathaway, considered the king of cash with almost $300B in the third quarter of 2022. Other cash-rich companies are Apple (AAPL) and Microsoft (MSFT).
4. Buy or Invest in Real Estate
In many cases, real estate prices increase faster than interest rates, sometimes even faster. Another option to benefit from a rising rate environment is to invest in real estate or real estate investment trusts (REITs).
During periods of economic growth, REIT prices tend to rise along with interest rates. The reason is that a growing economy increases the value of REITs because the value of their underlying real estate assets increases.
For individuals who must borrow money or make a purchase on credit, rising interest rates may seem like a bad thing, but investors can benefit if they plan ahead and acquire the correct kinds of products.
5. Short Bonds
Interest rate risk refers to the potential for an investment's value to decrease as interest rates rise. Bonds and other fixed-income instruments are subject to this kind of risk. You could protect yourself by selling short on the government bond futures market if you own bonds or shares in a bond ETF and anticipate cutting a loss due to an increase in interest rates.
For instance, if you believe the Federal Reserve (FED) will raise interest rates, you could choose to "sell" a derivative and start a position on US Treasury bonds. Your potential profit would lessen the loss to your other investments if your prognosis proved accurate and bond prices fell.
Predicting Central Bank Rates
A trader can plan and get ready for an interest rate change using information from these and other economic indicators. Strong economic growth may result in unchanged rates. The central bank may hike rates if the economy is overheated. On the other hand, evidence of weakness may signal a rate drop to promote borrowing.
By paying attention to significant announcements and studying economic forecasts, it is also feasible to anticipate an interest rate decision.
Important remarks made by central bank officials can reveal crucial details concerning changes in interest rates. They must not be disregarded in favor of economic metrics alone. Traders can learn more about a central bank's perspective on inflation and potential future actions when one of the eight main central banks' boards is set to speak in public.
By examining forecasts, one can predict interest rate decisions in a second method. Interest rate movements are predictable. Brokerages, banks, and experienced traders will therefore already be aware of what the rate is likely to be, in most cases.
For a more precise forecast, traders can average four or five of these predictions (which should be fairly close).
You can also review some of our top forecasts and price predictions:
Analysts frequently concentrate on the near future. Forecasts for long-term interest rates cover the following year and the ten Federal Open Market Committee (FOMC) meetings. They shed light on predictions for interest rates over the next five years.
Keep in mind that predictions of interest rates for the next five years made by analysts and algorithms can be inaccurate. Forecasts of interest rates shouldn't be utilized in place of your own research and analysis. Also, never trade or invest money that you cannot afford to lose.
Summary of interest rates and your investments
In summary, when interest rates are lowered:
When interest rates rise:
Because interest rate fluctuations can affect investments in different ways, there is no single action you should take when they change.
Stay focused on your financial goals, stick to your plan, and work with your financial professional to construct a portfolio that is diversified enough to help weather any short-term effects of a rate change.
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Our demo account is a suitable place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how trading and investing work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for stock investors who are looking to make a transition to leveraged trading.