You may have seen media headlines about how in the past year interest rates are up again and how stocks are tumbling. The interest rate hikes used by the Federal Reserve to fight inflation have led to pain in the stock market.
If you’re an investor or interested in building a portfolio, it’s important to understand how interest rate increases affect the stock market and your investments.
Key learning points
- Following the Fed’s most recent rate hike, we’ve seen 10 consecutive rate hikes since March 2022.
- When interest rates rise, consumer demand decreases, leading companies to report lower earnings.
- When inflation is high, the cost of doing business rises for most companies. Investors are concerned about how stocks will perform in the future, so they start selling their investments.
The series of rate hikes
When the Fed raises interest rates by 50 or 75 basis points, the stock market usually immediately reacts negatively to the news. For example, by the end of trading on September 26, 2022 — a few days after the Fed hiked rates by 75 basis points — the S&P 500 hit a 2022 low. The Dow Jones Industrial Average entered a bear market. At that point last year, every U.S. stock market index was in a bear market as fears of a global recession loomed large.
And since then five more rate hikes have followed. The most recent rate hike took place earlier this month and was the third consecutive rate hike of 25 basis points.
Any rate hike in 2022 in 2023 had an immediate impact on the stock market. Let’s take a look at how interest rate hikes affect stocks and the logic behind them so you can better understand what’s happening right now.
Why did interest rates rise again?
Federal Reserve Chairman Jerome Powell has made it clear since last year that the central bank will continue to raise interest rates until the battle against rising inflation is over. Powell has said there is no painless way to fight inflation, although the Fed’s efforts are clearly having an impact as inflation has fallen from its peak of 9.1% last June to less than 5% in April 2023.
As long as rate hikes continue, stocks could continue to fall as the rest of the economy also slows. Fortunately, the Fed has signaled that its rate hike in May may be the last rate hike we see in 2023. Further rate hikes would likely have led to further losses in the stock market for investors who have been dealing with market volatility for more than a year. year.
Rate hikes may stop for the time being as equilibrium in the economy is slowly restored. And while there was a point in 2022 when even Powell had a soft landing was unlikely, some experts now think it could happen. Other experts point to contracting real GDP growth in the first quarter as a signal that a recession will be announced later this year.
How do interest rate rises affect stocks?
When there is an announcement of a rate hike, we should expect some volatility in the stock market. The most recent rate hike led to the S&P 500 falling 0.7% as the market closed. The DJI dropped 200 points or 0.8%. The tech-heavy Nasdaq Composite saw a 0.46% dip.
Still, this was a fairly mild decline compared to the hits the market took during the fall of last year. In September 2022 – the day the Fed announced a 75 basis point Fed Fund rate hike – all three of the above indices fell by at least 1.7%.
During that stock market fall, stocks in travel and entertainment fell the most. Of the 20 stocks in the S&P 500 that fell the most, 18 were in this sector, as this is an area particularly hard hit during an economic slowdown. Consumers are less likely to spend money on travel and entertainment – less essential goods – if they fear a recession is imminent.
The Fed left options open for June after the May announcement. It is currently difficult to predict whether rate cuts will be imminent in the near future. More bad news could be on the way as some experts continue to predict a recession.
Why do interest rate hikes affect stocks?
The Fed is raising interest rates to cool inflation. Higher rates mean the economy won’t be as strong. But why is that? The Fed Funds rate affects the rate at which banks borrow and lend money overnight. Banks must meet reserve requirements related to the amount of cash they have on hand, so higher Fed Funds rates encourage banks to save less and borrow less.
In response to an interest rate hike, banks will typically try to raise interest rates on savings products to encourage consumers to deposit their money with the bank. They will also make short-term loans more expensive.
Variable interest rates, such as credit card rates, move in tandem with the Fed Funds rate. This is another downward pressure on consumer durables.
A rate hike is worrying news for investors, as it typically signals that companies will start reporting lower earnings as consumer spending falls.
This uncertainty naturally leads many people to sell their stocks and hold more money in cash. This starts a vicious cycle that won’t stop until we hit “bottom” and things start to look up. Insecurity and fear alone are enough to lead to irrational sell-offs. When investors see their peers selling stocks, they may simply join in out of fear.
Since the stock market is forward-looking, investors expect lower earnings in the future as the cost of borrowing money rises. The feeling is that consumer demand will decline as rates rise.
People could also sell their stocks to save personal money in the event of a layoff or other disaster, as it is likely that any rate hike could be the trigger that sends the economy into recession. The entire economy suffers when we are in a recession and job losses are common.
Are all stocks equally affected by interest rate hikes?
Rising interest rates mean that borrowing money costs more, so consumers are likely to buy fewer things and borrow less money. It’s reasonable to conclude that discretionary spending will decrease because people will think twice before making extra purchases they don’t need. Consumers will put vacation plans, purchase expensive electronics, or move to a larger home on hold.
That being said, while people might hold off on spending on a vacation or buying a new vehicle, folks still have to eat and keep the light on in the house. Thus, some stocks are recession-proof because their companies sell supplies that are in demand during each economic cycle.
Companies in industries like health care or consumer staples generally outperform most because demand isn’t slowing down too much as people still need their recipes and food for their families. Utilities are also doing well, since we all need electricity. Discount retailers may also see their profits unchanged (or increase) as people try to save money across all areas of spending.
It is also worth noting that highly indebted companies are more affected by interest rate hikes as the debt they have to pay now comes with a higher cost. Companies with cash reserves are protected in these confusing times.
However, when there is a stock market crash or sell-off, many companies are affected, even if they currently have strong financial positions or appear recession-proof. A stock market sell-off is not always a rational event, as investors panic and make decisions based on fear.
How can you invest during interest rate hikes?
It can be difficult to adjust your portfolio and plan accordingly while there is so much uncertainty in the economy. The main problem with interest rate hikes is that they could push us into a recession that will affect the entire economy. Consequently, even well-balanced investment portfolios can fall in the short term.
There are many reasons why rate hikes affect the stock market, and it looks like we should expect more bad news in the coming weeks. That’s why it’s often a good idea to update your portfolio’s allocation to make sure you’re protected. There are ways to make your portfolio more defensive. Diversification of your positions is often a good strategy.
It comes down to
With rates rising hopefully for the last time this month, it is clear that the Fed will continue its rate hike campaign until the economy stabilises. Hopefully we have almost reached that point.
The Fed raises interest rates to counter the high inflation in the economy. Higher rates affect the cost of short-term borrowing and encourage consumers to save more and move their money out of riskier assets such as the stock market.
There will be a lot of volatility in the stock market until everything blows up. You should take this into account when planning your investment strategy at the end of the year. The only sure thing is that all eyes are on the Fed as investors and companies try to figure out how to navigate this situation. We’ll also see how past rate hikes impacted consumer spending as publicly traded companies begin to release their next earnings reports in the coming months.
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