In an effort to get inflation under control, the U.S. Federal Reserve has been aggressively raising interest rates. Already, the Fed has raised rates much higher than most had expected at the start of the year.
Now, as Fed Chairman Jerome Powell signaled following the most recent rate hike, the central bank is expected to keep raising rates into next year even at the cost of slowing down the economy.
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:
- Why the Federal Reserve raises interest rates.
- How the Fed raising interest rates can affect the stock and bond markets.
- How to invest your money when interest rates are rising.
Why Does the Federal Reserve Raise Interest Rates?
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?”
How the Fed Raising Interest Rates Can Affect the Markets
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.”
How to Invest Your Money When Interest Rates Are Rising
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.
- Favor stock sectors that typically benefit from rising interest rates and lighten up on those that don’t: The earnings of many financial-services stocks—bank stocks, in particular—should benefit from rising interest rates. Meanwhile, utilities stocks become less attractive when rates rise, as their dividends become less appealing as the yields on bonds become more competitive. (For more on this topic, watch “What Rising Interest Rates May Mean for Utilities Stocks.”)
- Dabble in value stocks: Value stocks—which are typically undervalued relative to their worth, pay dividends, offer modest growth, and often cluster in what many would consider to be “stodgy” industries—should theoretically outperform growth stocks during periods of rising interest rates, because a growth stock is worth less than a value stock when interest rates rise. Dig deeper into this concept in “Will Rising Rates Provide an Advantage for Value Stocks?”
- Consider shorter-term investing: As mentioned elsewhere in this article, longer-term bonds are more sensitive to interest-rate movements. Some investors who own bonds might therefore consider moving into some shorter-term bonds or bond funds, especially if they expect to need to tap into those dollars in the next three to five years. Find some great fund ideas in “The Best Short-Term Bond Funds.”
- Hold enough cash if you’re nearing or in retirement: Morningstar’s director of personal finance and retirement planning Christine Benz suggests that investors in these life stages maintain five to 10 years’ worth of portfolio withdrawals in safe or short-term investments. For some ideas about where to put those safe dollars, read “The Best Places to Park Your Short-Term Investments.” And watch Benz discuss the topic in this video, “What Rising Interest Rates Mean for a Retirement Portfolio.”
- Investigate bank-loan funds: Some funds invest in bank loans, whose payouts adjust or “float” upward as interest rates rise. As a result, funds that invest in bank-loan funds have been popular this year. Get an overview of these funds, how they work, and their risks in “Can Floating Rate Funds Offset the Risks From Rising Interest Rates?”
Additional Resources for How to Invest Your Money When Interest Rates Rise
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.
- “Is Your Portfolio Ready for (More) Rising Interest Rates?”: With rates on the move in 2022, here’s how to assess your stock, bond, and cash holdings.
- “What Do Rising Interest Rates Mean for Diversification?”: A rising interest-rate environment may increase the performance relationship between stocks and bonds.
- “What Rising Interest Rates May Mean for Stocks and Bonds”: These types of stocks and bonds may outperform as interest rates climb this year.
- “What Do Rising Interest Rates Mean for Dividend Stocks?”: Here’s the effect high inflation and interest-rate hikes may have on dividend-paying names in 2022.
- “Amid Rising Interest Rates, These Equity-Income Funds Offer a Lot to Like”: These equity-income strategies tend to hold up better in market selloffs while providing a reasonable income stream.
- “Dividend Investors: Don’t Sweat Rising Interest Rates”: As the Fed raises interest rates, owning quality companies that regularly return cash to shareholders remains a solid strategy.
- “Should You Invest in Individual Bonds or Bond Funds Today?”: It’s a good question, given the weak performance of bond funds in the face of rising interest rates in 2022.
- “3 Bond Funds for a Rising Interest-Rate Environment”: These bank-loan and inflation-protected funds should be able to stand up against rising rates.
- “2 Bond ETFs for a Rising Interest-Rate Environment”: These exchange-traded funds focus on short-term bonds that may be less vulnerable to interest-rate hikes.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.