The Impact of Rising Interest Rates and How to Prepare
By Bill Addiss
It is not an understatement to say that interest rates, or the change in interest rates, impacts virtually every asset class: equities, bonds, currencies and commodities. Although interest rates have risen slightly over the past year, the Federal Reserve is now offering unprecedented transparency, making clear their desire and intention to raise short term interest rates. This article is intended to highlight the correlation between interest rates and these asset classes, focusing on the traditional impact that rising rates will have.
It is important to remember, however, that interest rates are not the ONLY factor for determining how assets will perform, any more than the earnings of a company are the ONLY determinant of a stock’s value, but it certainly is a very important determinant.
Rising Interest Rates = Declining Bond Prices
First and foremost, rising interest rates cause the price of outstanding bonds to decline. This is because, as interest rates rise new bonds are offered at these new, higher rates of interest. Since the new bonds offer higher interest rates, the attractiveness of existing bonds at lower rates declines. This inverse relationship between price and yield is fundamental and critical to understanding bonds. New bonds offering higher returns cause the price of older bonds offering lower interest rates to decline.
Rising Interest Rates = Declining Stock Prices
Rising interest rates traditionally result in lower stock prices for two reasons. As interest rates rise, income generating investments become more attractive to investors. Investors will be more likely to purchase assets into income generating investments (like bonds or CDs) and less likely to invest in stocks. In a rising rate environment, we see an inflow of money into income generating investments and an outflow of money from equities. Less demand for equities ultimately results in lower prices being paid for them.
Additionally, rising interest rates tend to hurt corporate profitability. It costs more for companies to borrow money, buy inventory, expand facilities and pay salaries, all of which hurt corporate profitability and, accordingly, depress stock valuations. There is one noteworthy exception to this, namely stocks in financial services companies. Bank, brokerage, insurance company and mortgage originator earnings often increase as interest rates move higher, because they can charge more (in the form of interest) for the money they lend to companies and individuals.
Rising Interest Rates = Rising Currency Value
Higher, or rising, interest rates traditionally increases the value of a country's currency. Higher interest rates tend to attract foreign investments and investors, increasing the demand for and value of the country’s currency. Alternatively, low or declining interest rates tend to discourage foreign investors and therefore decrease the currency's value.
Certainly, interest rates alone do not determine a currency’s value. Economic stability and the demand for a country's goods and services are also of importance. Favorable economic numbers such as a large Gross Domestic Product (GDP) and level balances of trade (imports vs. exports) are also key figures that analysts and investors consider in assessing a given currency.
When referring to the U.S. dollar there is another important consideration: the U.S. dollar is a reserve currency. This means that many foreign central banks hold substantial amounts of U.S. dollars. This is partly because globally, commodities like gold and oil are traded in U.S. dollars but also because, due to relative economic and political stability, the dollar has historically been considered a global haven of safety in an uncertain world. Due to these considerations, despite historically low interest rates here in the U.S. for the past 10 years, the dollar has shown strength relative to most other global currencies.
Rising Interest Rates = Declining Commodity Prices
History has demonstrated that higher interest rates in the United States, and around the world, will negatively impact the price of commodities.
When interest rates rise, the cost of capital (e.g. in the form of bank loans) to purchase the commodities increases thus driving up the carrying (or holding) cost of these inventories. Since the cost of capital is higher, holding or warehousing large quantities of these commodities is no longer cost efficient. That encourages consumers of raw materials to buy these commodities only on an as-needed basis rather than holding large stockpiles.
Gold is sometimes thought to be an exception to this rule and, certainly, the price of gold responds to a number of different factors. The primary difference between gold and other commodities is that many investors feel gold is a haven of safety and is, therefore, an effective inflation hedge (meaning as inflation or interest rates rise, the value of gold would also rise). History also shows us, though, that a lowering interest rate environment results in rising gold prices, and higher interest rates reduces gold prices.
Since 1975 (when gold futures began trading), there has been an inverse relationship between gold and real interest rates. Gold has generated positive returns during periods of falling real interest rates and negative returns during periods of rising real interest rates. The exception to this is when economic uncertainty is the cause of the inflation. In this case, gold prices will increase despite higher interest rates.
Again, interest rates are not the only factor that impacts the value of other assets like stocks, currency and commodities, but history has shown us that changes in interest rates do impact the prices of all these assets. Whether investing in these assets for long term or trading them actively, it is wise to know how these changes impact the market.
Responding to Rising Interest Rates
For the Bond Investor: Higher short term rates now make them more attractive than a year ago. That, plus the flat yield curve (long term rates not being substantially higher than short term rates) means that income-oriented investors should invest in short term instruments (Treasury Bills, CDs, short maturity corporate or municipal bonds). Also, the fact that these investments will mature in the short term gives you the opportunity to reinvest the proceeds at the expected higher rates when your bonds mature. Another suggested strategy is to invest in floating rate instruments (like TIPS, floating rate bonds). Given the expected rise in rates, the investor will benefit from this and be rewarded with rising coupons and income on their investments.
For the Borrow: For individuals seeking to borrow money, the rise in rates should be a call to action. Waiting will only cost you. As the past year has shown, the interest rates on mortgages, home equity loans and personal loans have all risen. This is only expected to continue, so in this situation, time is money. Delaying your decisions will only result in more expensive borrowing.
For the Equity Investor: The fact that interest rates were so low here in the U.S. for so long acted as buoyancy for the stock market as investors sought other investments. Accordingly, the rise in rates should act as a hinderance to further stock appreciation.
About the Author
Mr. Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments.