As the Fed Hikes Interest Rates to a 22-Year High, Investors Should Get Used to the New Normal
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The Federal Reserve just raised interest rates — again.
On Wednesday, the central bank announced another quarter-point hike for the federal funds rate. That brings the target range to between 5.25% and 5.5%, which is its highest level in more than two decades.
This is the 11th rate hike in the Fed's ongoing fight against inflation, and investors weren't surprised.
"The rate hike was expected, and the Fed is still telling us that they’ll evaluate future rate hikes as incoming data comes out," says eToro U.S. analyst Callie Cox. "Now, the question is how long the Fed will keep rates at these levels."
What's next for interest rates?
It’s possible that this will be the Fed's last rate hike in its current cycle, but it's also possible that investors will see more rate hikes this year. It all depends on the path of the economy.
In a press conference on Wednesday, Fed Chair Jerome Powell said that while price growth has moderated over the past year, "the process of getting inflation back down to 2% has a long way to go." He also acknowledged that despite signs that balance is returning to the jobs market, labor conditions remain "very tight."
Whether or not it's the last hike for the time being, investors shouldn't expect rate cuts any time soon. Back in June, when the central bank decided to keep rates where they were instead of raising them, Fed Chair Jerome Powell emphasized that while the central bank will plan to reduce interest rates as inflation falls, that could happen "a couple years out."
That means that there’s a good chance the Fed will leave interest rates high while the economy stabilizes. Central bankers have also indicated that more hikes could be necessary if they aren't satisfied with the progress of the economy.
What do higher interest rates mean for your investment portfolio? Here’s what you should know.
What do high interest rates mean for the stock market?
The Fed raises one single interest rate — called the federal funds rate — in order to make it more expensive for banks to borrow money from each other. Those extra expenses trickle down throughout the economy, too, to both companies and consumers. That's how the Fed slows down economic growth and prevents the economy from overheating.
When interest rates are high, banks charge companies more in interest on loans. That means that the types of companies that borrow a lot of money, like high-growth early-stage startups and tech firms, tend to see the biggest changes to their bottom lines.
Companies that rely on borrowing money to sustain their businesses "have higher costs and higher borrowing costs, which leaves you less money to invest in your business," explains Brian James, director of investments at Ullmann Wealth Partners. As profits fall and margins shrink, it’s not uncommon to see the stock prices fall too.
Rising rates also affect valuations for these kinds of companies. As debt becomes more expensive, the future cash flow of these firms becomes less valuable. That also puts pressure on stock prices.
Other more established business models with strong cash flows, like financial firms, generally weather high interest rates better than growing, early-stage firms because they’re less dependent on debt.
Higher interest rates can also put pressure on the market as a whole. When economic growth slows, consumers tend to spend less. Less consumer spending means slower growth, and that can weigh on stock prices.
What do high interest rates mean for the bond market?
High rates can trigger movement away from stocks and into other areas of the market, like bonds.
When rates are high, bond yields (the amount of return an investor will receive on the bond) tend to rise. And when that happens, “more money flows out of stocks and into less risky investment securities,” explains James Franke, a managing partner at Rothschild Investment. That’s because you can obtain that same rate of return while taking less risk, he says. (Reduced demand for stocks can depress their prices, too.)
Rising yields are a double-edged sword in the bond market because they're often paired with falling prices. Bonds with longer durations (a longer period of time before investors get their money back) tend to fare worse under rising interest rates than those with shorter durations, since the longer term means there's a bigger risk that interest rates will change again and reduce the value of the bond.
How should investors react to high interest rates?
In general, financial advisors don't recommend making major changes to your portfolio in response to fluctuations in interest rates. If you're a long-term investor, you likely don't need to worry about moving your money between different durations of bonds or different types of companies in the stock market with every change in interest rates.
"It's more about...having a systematic process to planning and investing so you can weather all of these storms — which are normal," James says.
But if you haven't checked in on your portfolio in a while, now could be a good time.
"Most investors are now significantly overweight equities," Franke says. And it's no wonder so many people have preferred stocks for so long: Relatively low interest rates over the past decade helped fuel enormous gains in the market.
But now, with rates high again and likely staying that way for some time, Franke says diversification is more important than ever. Some investors may benefit from revisiting other asset classes like bonds, he says, which "are now offering much more attractive rates of return than they have for the past 15 years."
Overall, he recommends that investors take this opportunity to rebalance their portfolios, revisit their asset allocations and make sure they're on track to meet their goals.
This story has been updated to reflect the Federal Reserve's interest rate hike on July 26.
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