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Rising Interest Rates: What Today’s Investor Needs to Know

By on January 3, 2022
Categories: MARKET NEWS, Uncategorized

We hope you enjoyed a wonderful holiday season with friends and family and find yourself refreshed as we begin the new year.

With the economy recovering from the short-lived recession – and inflationary price gains squeezing consumers – Federal Reserve (Fed) officials are rolling back their accommodative policies and preparing to raise interest rates, perhaps multiple times this year. More specifically, the Fed’s policy-setting committee vowed in late 2021 to raise its benchmark interest rate up to three times in 2022. Since the Fed typically adjusts interest rates to moderate the growth or contraction of the economy, this announcement signaled their belief that the economy is emerging from the pandemic-induced downturn, and undesirable persistent inflation may be resulting from an overheating economy.

As the Fed began winding down its “dovish” approach to monetary policy, global investors closely monitored the Omicron coronavirus variant as new restrictions and closures dampened holiday travel. Additionally, concerns about rising prices and growing supply chain issues around the globe remained top of mind. Even with notable economic headwinds, U.S. stocks had an outstanding year in 2021.

Asset class returns for the fourth quarter and full year 2021 were as follows:

 

Index

Asset Class

Fourth Quarter 2021

Full Year 2021

Barclays U.S. Govt./Credit—Int. Fixed Income -0.6% -1.4%
S&P 500 Large U.S. Stocks 11.0% 28.7%
Russell 2500 Small/Mid U.S. Stocks 3.8% 18.2%
MSCI ACWI ex-USA Foreign Stocks 1.8% 7.8%
S&P Global REIT Real Estate Securities 12.4% 31.4%

Understanding that rising interest rates may be part of the investment landscape for the foreseeable future, we think it is pertinent to highlight several potential implications of an upcoming shift in U.S. monetary policy.

  • There is no need to rush large purchases as borrowing rates remain near historic lows, but adjustable-rate loans may be of concern. Now is a good time to consider the impact of rising interest rates when securing a home mortgage, but there is no need to feel rushed to make purchases. The Fed typically determines the target interest rate for very short-term debt, but it has only indirect influence over longer-term rates. Consumers may feel more of a “pinch” with adjustable-rate mortgages (ARMs) and home equity lines of credit (HELOCs); however, these loans are generally based on benchmarks that reference the fed funds rate or other variable rates. Homeowners who have an adjustable-rate mortgage could see their borrowing costs rise and may consider refinancing to a fixed loan, which offers fixed monthly payments for the term of the loan.
  • Higher rates on savings accounts and money market funds may be on the way, but not immediately. If you have money in a savings account or a certificate of deposit, you likely earned very little interest in 2020 and 2021. While large banks may waste no time in charging higher interest for loans as the Fed begins its interest rate hikes, they are also sitting on historically large amounts of cash deposits. Big banks don’t need to immediately increase yields on deposit accounts and may move slowly to raise rates on short-term deposit accounts. High yield online saving accounts, however, may react more rapidly to Fed rate changes because there is much more competition for new deposits.
  • As interest rates rise, the U.S. dollar may strengthen against global currencies. Global currency markets could become more volatile as the divergence between U.S. and foreign interest rates may strengthen the U.S. dollar. As investors pursue higher rates available in U.S. bond market, demand for the U.S. dollar may increase, boosting the value of U.S. currency across global markets. While this would be positive news for Americans travelling abroad, U.S. companies that sell goods abroad may be adversely affected by a strengthening U.S. dollar.
  • It is difficult to find consistent patterns in stock market behavior when interest rates rise (or fall), as many economic factors are in play. It is probably not surprising that stocks have provided more attractive real returns in a declining interest rate (less inflationary) environment. But even when rates rose and higher inflation prevailed over multi-decade periods, stocks still managed to deliver attractive long-term returns.

For example:

    • From January 1, 1950 to September 30, 1981, the 10-Year Treasury note yield rose from 2.32% to 15.84%. During this prolonged period of interest rate increases, the S&P 500 Index produced an annualized return of approximately 10.79% (with dividends reinvested). After accounting for inflation, this represented a real return of 6.10% per year.
    • From October 1, 1981 to November 30, 2021, the 10-Year Treasury note yield fell from 15.75% to 1.43%. During this prolonged period of interest rate decreases, the S&P 500 Index produced an annualized return of approximately 12.36% (with dividends reinvested). After accounting for inflation, this represented a real return of 9.34% per year.
  • Bonds remain a critical component of a diversified portfolio, even as rates rise. It is reasonable to ask, “Why should I invest in bonds if we expect interest rates to continue increasing, and bond prices to decline as a result?”. In well-functioning capital markets, today’s bond values reflect everything the market knows about economic conditions, growth expectations, inflation, and monetary policy. Accordingly, the expectation of rising rates is largely factored into bond prices. As proven time and again, no one can accurately and consistently predict short-term market performance (e.g., the sudden pandemic-induced market downturn in early 2020). Without knowing the exact timing or magnitude of interest rate changes, short-to-intermediate term bonds remain the stable asset class during times of heightened stock market volatility. A return to more normal yields is a healthy long-term trend as higher levels of income may be realized in the future.

While the actions of the Fed in the upcoming months and years may have short-term implications for both the U.S. and global economy, our focus remains on the factors that most influence long-term investment success for our clients; i.e., managing overall portfolio risk, appropriate diversification, disciplined rebalancing in times of market volatility, and minimizing portfolio costs and taxes.

Tax Season

In mid-February, clients with taxable accounts can expect to receive Form 1099-Composite, which combines information on interest income, dividend income, mutual fund distributions, and security sales with resulting gain or loss, from your account custodians (e.g., Charles Schwab & Co., Inc.). As always, we will be coordinating efforts with our clients’ tax preparers to ensure the appropriate information is readily available. If you have changed your tax preparer, please let us know at your earliest convenience.

We are deeply grateful for the trust you have placed in our firm. We encourage you to call or e-mail anytime you would like to discuss your portfolio or other financial matters. We wish you the very best in 2022!

Sincerely,

Dowling & Yahnke Wealth Advisors

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