How to Play a Rate Hike

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The markets have predicted a 50-50 chance that the Fed will raise rates again this December and investors are on the fence as to how this could benefit them. The election cycle has complicated matters leaving many investors on the sidelines until the vote comes in and uncertainty abates a little in the markets.

Last December the Fed raised the Federal Funds rate by 0.25% marking the first increase since 2006 in what was widely believed to be a series of hikes. However, the markets plummeted early in 2016 following the hike and the Fed’s statements have changed from hawkish to dovish with little consistency. Keeping a rate hike on a set schedule is critical to maintaining stability in the markets, but another rate hike in December without seeing a rise in inflation could also tip the scales in a bearish direction.

Regardless of the Fed’s decision next month, investors need to have their portfolio’s prepared for the worst while still positioning it to take advantage of any potential gains.

The relationship between interest rates and stocks

Interest rates impact the cost someone pays for the use of another person’s money. When the Federal Funds rate goes up, it increases the cost banks are charged in order to borrow from the Federal Reserve. The goal is to reduce the money supply in an attempt to curb inflation.

Increased rates have widespread implications though. Higher rates means that borrowers pay more for loans and reduces the amount of money they are able to spend on other goods and services. For businesses, that means there is less capital to put towards investments or growth and reduces earnings due to the increased amount spent on interest payments.

When earnings go down, so do stock prices. So when interest rates go up, the immediate effect is usually a decline in stock values since profits take a hit due to the increased borrowing cost. It also makes more conservative asset classes like treasuries and bonds more desirable since yields go up. Stocks have more risk, while bonds have less.

Stocks need to be more valuable than the less risky bonds and treasuries in order to be more desirable to investors. For investors, that means a stocks return needs to be equal to or greater than the risk-free rate plus a risk premium. For example, let’s say the risk-free rate is 2% while XYZ’s risk premium is 8%. That means investors will expect the stock to generate a 10% return in order to be desirable. If the risk-free rate rise due to a Fed hike to 3% then the stock would need to produce a return of 11% to get the same result. As rates go up, stocks need to produce higher and higher return in order to compensate for the risk.

Final thoughts

Not all stocks are affected the same by higher interest rates. Increased rates also mean greater returns on money market accounts and other conservative asset groups. This benefits financial companies the most like banks and insurers who keep significant sums of money in liquid assets in order to make loans and pay out insurance claims.

Investors who worry that a rate hike might hurt their portfolio might consider picking up some financial stocks to hedge against higher interest rates. Investors should also note that once the rate hikes stop, a new equilibrium will settle over financial markets with stocks compensating for the changes and producing higher returns in the long run.