How Rising Rates May Impact Your Portfolio
The Federal Reserve has acknowledged that the post-pandemic inflation we have seen isn’t as transitory as once hoped. Supply chain issues haven’t cleared up as quickly as expected and inflation is beginning to take its toll. In an effort to tamp down inflation, the Fed has begun a series of rate hikes that are expected to continue throughout 2022. In this month’s blog post, we’ll look at how an environment of rising rates will impact the financial products we use in our daily lives like mortgages, savings accounts and CDs, bonds, and stocks.
In its largest rate hike since 2000, on May 5th, the Federal Reserve increased the federal funds rate by 0.50% and projected that these rate hikes will continue another six times throughout the year. The federal funds rate is the rate that banks charge when they lend each other money to satisfy their overnight reserve requirements. Because the fed funds rate is the basis of most other interest rates, raising this rate is the Fed’s way of making it more expensive to borrow money throughout the economy. More expensive borrowing means less borrowing and less borrowing means less spending. The desired effect of these rate hikes is to reduce the money supply circulating in the economy and bring inflation back down to a more normal range. So, what type of impact will these rate hikes have on our everyday lives? Let’s take a look at a few examples.
The fed funds rate is such a powerful tool in the Fed’s toolbox because it is the rate that many other rates are based on. As the fed funds rate increases, yield on Treasuries typically increase as well. Mortgage rates are largely based on the yield of the 10-year Treasury which had seen its biggest monthly increase since 2009. This has caused the average interest rate on a 30 year fixed mortgage to go from 3.59% on January 1st of 2022 to 5.57% as of May 13th 2022 (www.bankrate.com). To put this in perspective, a $300,000 30-year fixed rate mortgage at 3.59% costs a total of $490,410.31 over the life of the loan. That number jumps to $617,963.76 over the life of a $300,000 30-year fixed rate mortgage at 5.57%!
Even thought that is a drastic change over the life of the loan, the flip side is that higher mortgage rates can reduce the number of potential home buyers, reducing housing prices. With a historic lack of housing inventory, the relationship between mortgage rates and housing demand probably won’t behave exactly as it has in the past but, that’s a topic for another blog!
- CDs and Savings Accounts
While an increase in the fed funds make mortgages cost more over time, it can also increase the interest earned on our savings. Since the start of 2022, the average rate on a 1-year CD has gone from a paltry 0.50% to a still paltry but much less so 1.53% on May 13th. (www.bankrate.com) We’ve become accustomed to our savings earning very little over this past decade so, while still low and far under inflation, for many, these guaranteed rates are a welcome change.
You would expect our savings accounts to follow suit but, with bank deposits at commercial banks going from about $13 trillion pre-pandemic to over $18 trillion as of May 16th , banks have little incentive to increase the rates on our savings accounts. They just don’t need to spend the money to attract additional cash savings. The savings are already there.
Bonds are near the top of the list of financial instruments that are susceptible to changes in interest rates. The reason why is a fairly simple concept to grasp. Let’s say that I currently hold a bond that pays 3%. As new bonds are issued during a period of rising rates, they will pay something higher than what the bond I currently hold pays. 3.50%, for example. Since new bonds pay 3.50% and my bond only pays 3%, the demand for my bond naturally falls. With less demand, the price that someone is willing to pay me for my bond yielding 3% drops. This is why bond yield and bond prices move inversely with each other. Put another way, as bond yields go up, bond prices go down.
We can limit this price erosion in a couple different ways.
One way to limit the drop in bond prices is to purchase an individual bond and do nothing. Bonds are set up with a purchase price (face value), an agreed upon yield, and – most importantly for this example – a maturity date. If you hold a bond all the way to maturity, the bond issuer returns all of the money (as long as they do not default) you initially invested when you purchased at the bonds face value. You are no worse the wear except for missing out on the additional yield you could have received from a more recently issued bond.
The other, and far superior way is to create a bond ladder. Bond ladders are made up of individual bonds with incrementally increasing maturity dates. For example, you could purchase bonds maturing in one, two, three, four, and five years. After the first year, when your one-year bond matures, the proceeds from that bond are used to purchase a new five-year bond at a presumably higher interest rate if rates continue to rise. By purchasing bonds in this manner, you are constantly reinvesting a portion of your bond portfolio into new bonds which keeps you from locking yourself into a single interest rate.
There is a more indirect relationship between stocks and interest rates. Conventional wisdom states that, when interest rates rise, stocks will generally fall and vice versa. This relationship is expected because as borrowing costs rise, the costs of doing business rise as well, making growth and profitability tougher to achieve. Investor sentiment is involved as well and a prolonged period of slow economic growth or even a contraction can make the allure of higher interest rates in fixed income more attractive.
The type of stock makes a lot of difference when looking at the effects of interest rates as well. Growth stocks, for example, almost always fall when interest rates rise. This is not only due to higher costs of business and investor sentiment but also due to the way that stocks are valued by analysts.
Time to nerd out a bit! When looking at the expected cash flows of a growth stock, an investor typically expects several years of low or no revenue until -hopefully- much higher revenue is achieved down the road. An analyst will look at these expected cash flows and “discount” them by a risk-free rate of return to get an estimate of what those future cash flows would be worth if they were paid today. This is derived from a concept known as the “time value of money” and is an integral piece of investing. Put simply, a dollar today is worth more than a dollar one year from now and a dollar one year from now is worth more than a dollar two years from now and so on.
So, what do analysts use to represent this risk-free rate of return? Most use US Treasury Bills or T-bills. These are short term treasuries with essentially zero chance of default as they are backed by the US Government. Like other treasuries, these T-bills also follow suit with the fed funds rate. An increasing fed funds means a higher yield on T-bills. A higher yield on T-bills means that the present value of those future cash flows are not worth as much as they were before the yield on T-bills increased.
Here is a chart that shows the relationship between the discounted cash flows of a growth stock and a value stock. Again, growth stocks typically have very little revenue in their early years with the expectation of much higher revenue in the future. Being a more mature business, value stocks typically already have a decent amount of positive earnings but the expectation for growth is far less. This chart shows a stream of cash flows that, over time, equal the same amount. However more of the growth stock’s earnings happen later.
As you can see from the chart above, the change in yield on the T-Bill from May 2021 to May 2022 has a much greater impact on the discounted cash flows of a growth stock (top) than it does on a value stock (bottom). In this example, the change from a risk-free rate of 0.04% in 2021 to 1.49% in 2022 resulted in a 12% decrease in the present value of the growth stocks future cash flows. Among other reasons, this concept is a major factor in the selloff we’ve seen this year in tech and other more speculative sectors of the market.
It should come as no surprise that the US economy and capital markets are extremely complex. The impact of rising rates has an even larger scope than what’s been covered in this blog and it’s important to understand how your own financial plan will fair in this current economic climate. Everyone’s situation is unique so please reach out to us at Innova Wealth Partners to see if you’re well situated to weather this period of rising rates.
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