How to Invest Your Money as the Fed Raises Interest Rates
Why the Federal Reserve raises interest rates, what that means for stocks and bonds, and how to tweak your portfolio in response.
In an effort to damp inflation, the U.S. Federal Reserve began raising interest rates in 2022. In fact, the Fed increased the federal-funds rate by three fourths of a percentage point in both June and July, the largest Fed interest-rate hikes since 1994. The federal-funds rate now ranges between 2.25% and 2.50%.
Fed chair Jerome Powell expects the range for the federal-funds rate to continue to increase until there’s evidence that inflation is moving down, closer to the Fed’s 2% target. How long that will take remains to be seen.
Against this backdrop of rising interest rates, investors may wonder how they should be investing their money today and if they should be making changes to their portfolios.
This special report explores:
The U.S. Federal Reserve is designed to help the economy stay healthy, which means maximizing employment and promoting economic growth while maintaining prices. The Fed does so by setting monetary policy.
For more about the Fed and what it does, read “What Is the Federal Reserve and How Does It Work?”
One tool that the Fed uses to help keep the economy healthy is the setting of interest rates—the Fed has the ability to lower interest rates (specifically, the short-term fed-funds rate) or, conversely, the Fed can raise interest rates.
In 2022, the Fed has been on a path of raising interest rates in an effort to combat high inflation, or the price of goods and services over time. How can rising interest rates quell inflation? Higher interest rates mean higher borrowing costs—and if it costs more to borrow, consumers will, eventually, spend less. And as consumers spend less, there’s less demand for goods and services, reining in inflation.
Watch this video to understand more about why the Fed is boosting interest rates: “Why Are Interest Rates Rising?”
The Fed raising interest rates can have a negative effect on both the stock market and the bond market.
First, let’s talk about the impact that rising rates can have on the stock market. When the Fed raises interest rates, it costs more for businesses to borrow money. And an increase in the cost of debt can impact a company’s profitability and, in turn, its stock price. Sometimes, however, companies will pass along those increased costs to consumers, who will then pay more for the goods and/or services the companies provide. At the same time, consumers are paying more to borrow, too, when the Fed raises interest rates. And if consumers are paying more in interest and facing larger bills for goods and services, they’ll have less disposable income to spend, which can, in turn, negatively affect company earnings and stock prices.
Now, on to the impact that rising interest rates have on bonds. There’s an inverse relationship between interest rates and bond prices: As interest rates rise, bond prices fall. Longer-term bonds—for instance, those with maturities of 30 years—are more sensitive to interest-rate movements than shorter-term bonds—those with maturities of three years or less. In addition, the higher-quality the bond is, the more sensitive it will be to changes in interest rates. For example, an AAA rated 10-year bond issued by the U.S. Treasury is more sensitive to interest-rate movements than a B rated 10-year bond issued by a corporation.
To better understand the math of bond investing, read this article: “Are Your Bond Holdings Vulnerable in a Rising-Rate Environment?”
It’s no surprise, then, that both the stock and bond markets have struggled in 2022 as the Fed has raised interest rates. For some perspective on the performance of the stock and bond markets in 2022, check out “14 Charts on the Market’s Second-Quarter Performance.”
At Morningstar, we believe that your investment goals—rather than what’s going on in the market—should determine how you invest your money. Put another way, we don’t think rising interest rates should necessarily change the way you think about investing your core portfolio—assuming that the asset mix in that core portfolio is aligned well with your time horizon. Most investors probably don’t need to make changes to their portfolios in response to rising interest rates.
That being said, some investors may be interested in tilting their portfolios toward stock sectors and styles that may be poised to benefit from rising interest rates. Others may be looking to invest a small bit of money in securities that may help offset the impact of rising interest rates elsewhere in their portfolios. If that sounds like you, here are a few ideas for how to invest when interest rates are rising.
Investing while the Fed raises interest rates can be frustrating, especially when both the stock and bond markets respond negatively. But for those investors who have portfolios that align well with their goals, no action may be necessary. Some investors, however, may want to try to capitalize on rising interest rates with a small portion of their money. Other investors are looking to add some securities that may offer some protection against rising interest rates. Here are some additional resources to help investors navigate their portfolios through a rising interest-rate climate.