Interest rates play a critical role in determining how the broad economy functions as well as how much you and I pay for everyday items when borrowing. At a high level, interest rates are thought of as the so-called “cost of capital,” which means that the higher they are, the more expensive it is to do business. The Federal Reserve greatly influences the short-term interest rate market depending on economic conditions.
Investors, meanwhile, are acutely aware of how even minor interest rate changes can impact the value of stocks and bonds. There are actions you can take to insulate yourself from interest rate risk in your portfolio.
The Basics of Interest Rates
Do you ever open your credit card statement and get that feeling of dread when you see what your current interest rate, or annual percentage rate (APR), is? Borrowers no doubt quickly understand that higher rates lead to tougher financial conditions since it means having to dole out more interest to cover your loans.
There’s another side to the coin, though. Savers rejoice when rates are on the rise – it means being able to earn more interest income. One of the fundamentals of how interest rates work is that for every asset there is a liability, so there is a winner and a loser when rates are on the rise.
Interest rates are the cost of doing business and are one of the biggest indicators investors use to decide on what asset allocation strategy to take. It is the annual amount a debtor pays on their loans and the yearly income a saver can expect when stashing cash away. There are many kinds of interest rates such as those on checking and savings accounts, high-yield and money market accounts, yield-to-maturities on bonds, mortgage rates, credit card APRs, student loan rates – and the list goes on!
How Compound Interest Works
Interest rates are so important because compound interest can either work for you or against you as a consumer and investor. What’s compound interest? It’s only the eighth wonder of the world! (So says Albert Einstein.) It’s earning (or paying) interest on interest. Let's roll through an example so that the point hits home:
Suppose you have $10,000 to invest for the long haul. You take a globally diversified approach and aim to earn the long-term average of, say, 9% annually. If you have a 40-year time horizon, then that $10,000 initial sum would hypothetically amass to more than $300,000 at the end of your time horizon. Pretty crazy, right?
Let’s flip the script. Now say you have a $1,000 credit card balance with a 20% APR. That means you’ll be hit with a monthly interest charge of $15.31. If you don’t pay your bill, then the next month you will owe a 20% APR on $1,015.31, which would be $15.54 of interest charged. Clearly, you want to pay off high-interest-rate debt as quickly as possible so that compounding doesn’t wreak havoc on your finances.
What’s the Federal Reserve? What is Monetary Policy? Why Does it Matter?
The Federal Reserve is the primary arbiter that dictates short-term interest rates, but longer-term rates are priced by the market. If the economy grows too quickly, causing inflation, the Fed is wont to hike rates to stymie growth, but during recessions and periods of extremely low inflation, then the Fed will slash its policy rate to spur consumer spending and encourage businesses to take out loans to stimulate the economy.
For example, following the 2008 Great Financial Crisis, the Fed, led by then-Chairman Ben Bernanke, embarked on what is known as quantitative easing in hopes of stimulating economic growth and even inflation. You see, during the 2008-09 period, the U.S. economy, for a time, experienced the devastating impacts of deflation – or a fall in consumer prices. That can lead to a downward demand spiral as folks put off buying items since they expect even lower prices in the future. To avoid that Great Depression-like scenario, Bernanke and the rest of the Fed slashed rates and purchased bonds to reduce interest rates. The price of a bond and its yield work like a seesaw – when there’s strong demand to buy a bond, its price rises, and the yield falls due to the inverse price-yield relationship.
Are you enjoying this “monetary policy 101” lecture? The bell hasn’t rung yet. Stay awake!
Now, let’s fast forward to recent times. In 2022, the domestic inflation rate surged to four-decade highs, stunning policymakers and investors alike. Fed Chair Jay Powell reacted by embarking on a swift and heavy-hitting hiking path. They took short-term rates from near 0% to above 4% in short order to cool off the economy. That was a key factor that led to 2022’s bear market in stocks and bonds.
How Consumers Feel Interest Rate Changes
So, there’s a new interest rate environment today compared to what was experienced by consumers during the previous decade. We see higher rates on savings accounts and steeper lending rates for would-be homebuyers. Gen Z and millennials are particularly in a tough spot since the Housing Affordability Index is near all-time lows, according to The National Association of Realtors. The fortunate groups of current homeowners are those who were able to lock in a 30-year fixed-rate mortgage for under 4% before 2022.
Consumers feel higher interest rates in other ways, too. Shopping for a car is made all the more stressful knowing that your auto loan rate will be less than favorable. And while we’ve touched on credit cards, student loan rates have some government backing so that their APRs are not too punitive.
How Interest Rates Affect Markets
It’s evident how interest rates affect all consumers, but higher lending rates are arguably more harmful to the younger crowd who rely on debt more than older folks who have higher savings and investment account balances. But changes in interest rates also greatly impact the prices of stocks and bonds as well as dividend yields on various investments.
Where ebbs and flows in rates are played out most clearly is in the bond market. Due to the price-yield seesaw, when rates rise sharply, bonds as investments can be a real stinker in the short run. Retirees know that all too well if they held bond mutual funds and exchange-traded funds in 2022. But here’s the upside to it: higher interest rates are actually good for bond investors so long as their holding period is longer than a bond’s yield-to-maturity since they can benefit from reinvesting into higher-yielding fixed-income securities. Still, 2022 was the worst year in recorded history for the U.S. aggregate bond index, and investors are only starting to recover.
As for stocks, higher rates can be a good or bad thing. On a spreadsheet, classic finance theory says that a higher cost of capital (i.e., higher interest rates) should mean lower asset prices and a reduced value in future cash flows due to the math behind discounted cash flow valuation. But in reality, higher rates can be caused by economic optimism that comes along with bull markets, too. That is not what happened in 2022, however. That year, rates surged due primarily to inflation. The S&P 500 fell more than 19%, but after inflation, that return was more like –26%. That’s the kind of impact a steep rise in rates can have on equity markets.
There is one more arena directly impacted by higher interest rates: currencies. This is a lesser-known area, but it’s huge. Like ‘the biggest market in the world’ huge. Higher rates in one country can cause its currency to soar in value as money flees low-yielding currencies. That’s about how it played out for the U.S. dollar in 2022 as it climbed to its highest value against a basket of currencies since 2002. As rates then pulled back domestically and climbed abroad, the greenback gave back some gains, and the euro, for instance, recovered. So, if you have plans to take a European vacation, you’re impacted by changes in interest rates as well!
Mitigating Interest Rate Risk
Your heart might be beating just a bit faster learning about all the possible pitfalls promulgated by higher rates. Have no fear! There are ways investors, businesses, and consumers can protect themselves against changing interest rates.
Diversification using a global macro strategy that includes owning emerging markets, crypto, real estate, and other asset classes can insulate you from wild moves in the rate market. What’s more, Allio’s strategy can even own assets that benefit from a particular interest rate regime. You do not have to stand idly by.
Bond investors can also use tactics such as laddering (investing in individual bonds with differing maturity dates, then reinvesting proceeds when the bond principal is repaid), as well as putting money to work in floating-rate notes that have a rate that adjusts with market rates. Treasury Inflation Protected Securities (TIPS) are another vehicle to buffer against high inflation that often coincides with rising interest rates.
If you own a small business, then you can engage in strategies to reduce the impact of rate fluctuations by hedging through swap contracts or other derivative instruments. It’s also crucial to assess whether fixed-rate or floating-rate borrowing is right for your firm’s situation.
First, if you are struggling with high-interest-rate debt, you might be able to negotiate with your lender about the terms of your loan. The last thing they want is to see you default on your financial obligation, so they might have some wiggle room on the rate charged or the due date. Next, like a business owner, it’s key to understand the risks and upsides to fixed and adjustable-rate financing. During periods of high rates that are expected to retreat, a rate that moves with how market yields are changing could be a good play. Or you can refinance (like with a mortgage) during periods of low rates.
The Bottom Line
Changes in the level of interest rates have an impact on nearly all facets of the economy. Nobody is immune, but there are ways to not only protect yourself as an investor and consumer. You can also benefit from higher or lower rates. For your portfolio and net worth trajectory, Allio’s team of hedge fund veterans can help your investment capital grow through our next-gen saving and investing app.
Using our global macro strategy, you can more easily ride through swings in the economy and have confidence that putting money to work across asset classes can help you better reach your financial goals.