If you invest in bonds, stocks, or other equities, learn about how rising or falling interest rates across the globe can affect prices, and how you can use this knowledge to manage risk.
Interest Rates and Equity Prices
One way to think about interest rates is simply as the cost of using someone else’s money. Since central banks print money, they can affect these rates by increasing or decreasing the amount that they charge other banks to access money. These changes have ripple effects across the entire economy as these higher costs are passed on to businesses and then consumers. In fact, interest rates are the main tool that those in power use to create monetary policy today. Central banks use interest rates to control inflation in two ways:
Raising rates: An increase in interest rates makes money more costly to borrow, shrinks the money supply, and prompts consumers to save.Lowering rates: A decrease in interest rates makes money cheaper to borrow, increases the money supply, and prompts consumers to spend.
Interest rates mainly affect equity prices through the way they sway business and consumer behavior. Raising interest rates causes businesses and consumers to borrow less and spend less. This makes sense, because if it costs more to borrow money, people would be inclined not to borrow as much, or to wait until the cost to borrow drops again. These types of actions lead to less revenue and net income, which in turn lead to lower stock prices. Price-earnings multiples (the ratio of share prices to earnings per share) will then drop, as investors expect lower returns. The opposite is true when interest rates are lowered: spending increases, stocks perform better, and financial health in a broad sense improves.
How Do Interest Rates Affect Discount Rates?
Interest rates also impact equity valuations by changing the discount rate. If the value of equity is equal to the value of all future earnings in today’s dollars, when you invest you must apply a discount rate that stands for the prevailing interest rate over the whole period. Rising interest rates mean that a company’s stock does not have as much value today as it did when rates were lower. In theory, they would reduce the stock’s valuation and the market price at the time of the rate hike.
How Do Interest Rates Affect Sectors?
Some sectors may thrive from higher interest rates, and some suffer more than others. For example, the financial sector tends to receive a boost when rates rise, because banks can charge more for lending money. Higher rates lead to an increase in mortgage rates, which in return produces a higher net interest margin for banks. But companies that manufacture products or deal in retail on a global scale often suffer when interest rates spike, because higher rates tend to mean the U.S. dollar is stronger, and the price of U.S. goods goes up in other countries. They may not be able to compete with local or lower-priced products that aren’t tied to the U.S. dollar.
How Do Interest Rates Affect Bond Prices?
Rising interest rates result in lower bond prices and higher bond yields, and vice versa when rates fall. However, not all bonds are the same. The prices of fixed-rate bonds, for example, tend to fall as interest rates go up. The price of bonds with longer terms tends to fluctuate more in relation to interest rates, while the price of short-term bonds tends to stay more steady. That is because there is less risk in holding a short-term bond until it matures, and so changing rates may not have as great an effect as they do on long-term bonds, where there is a greater chance that rates could change to a large degree by the time the bond matures. It helps to think about the effect of interest rates on bond prices in terms of how much risk you are willing to take: Rising rates are more likely to remain higher over a long period of time, which results in a greater opportunity cost when it comes to finding better bond yields elsewhere.
The Global Economic Recovery
Central banks lowered interest rates by a drastic amount in response to the 2008 financial crisis. In fact, many countries had near-zero, zero, or even negative interest rates. Central banks that were still experiencing a crisis then turned to monetary policies that were outside the norm, such as quantitative easing (QE), to bolster the markets and restore confidence. After many years, these strategies succeeded, and the market has since become stable to a large degree. By way of comparison, many of the same patterns emerged in the years following World War II. At the time, U.S. interest rates were very low, and the Federal Reserve held a large number of Treasury securities. The central bank began to hike rates in the early 1950s, and inflation remained in check through the early 1960s. The 10-year Treasury yield hit just 5%, but the S&P 500 rose by about 500%. This shows that equities can withstand rate hikes if the economy is strong. Other non-U.S. markets may see these same patterns as they begin to taper asset buying and raise interest rates. If you invest in bonds or stocks at a time when global interest rates are up, you should think about why rates are on the rise, rather than looking at it as an isolated event. There may be larger global forces at play. Even if U.S. equities happen to be holding up when rates are rising, international equity markets could outperform U.S. equities if their rates do not increase, given the strength of the U.S. dollar. The chart below shows the fed funds target rate from 2014 through the present.
How to Hedge Your Portfolio
There are many strategies that you may want to use when you invest internationally to hedge your portfolio.
How Should You Treat Bonds?
Bond prices are likely to decline whether interest rates increase in the future. One way to address this risk is to favor short-term over long-term bonds, and reduce the maturity of bonds in your portfolio. You can also adjust the asset allocation to favor more equities over bonds. This approach assumes a certain objective and risk tolerance, so it may not work for all investors, but it may be right for you.
How Should You Treat Stocks?
Equities may not be as likely to see a decline from higher interest rates, but certain sectors could gain and suffer more than others. Consumer staples, real estate, and utilities may see a contraction in valuations, since their dividends would become less valuable to investors. On the other hand, financials and industrials could outperform as interest rates rise. You may want to look into strategies like sector rotation to take advantage of these dynamics, as you invest in one sector or another.
