Why Rates Should Interest Investors
The Federal Reserve has begun raising interest rates to tame inflation. By setting the price of money at higher interest rates, the Fed hopes the price of everything else will stop going up so much.
This has a broad impact on your portfolio.
Higher interest rates make investments go down today so that new buyers can expect higher returns going forward. A better price for a buyer today means better returns tomorrow. The “better price today” means lower prices of stocks, bonds, real estate, and any asset providing a return that has to compete with interest rates.
Some parts of your portfolio will also be hit by the economy, slowing effects of interest rates.
Higher interest rates make for higher monthly payments on mortgages, making home purchases less attractive to borrowers. The same dynamic impacts business investments and consumer spending across the economy.
All else being equal that should reduce inflation by broadly reducing demand for goods and services. Less demand means less business, and that is bad for your 401k.
This one-two punch combination is what has led to the worst first half for stocks since 1970. But that record overly dramatizes the damage done to stocks so far because the market happened to top out just as the calendar changed. There have actually been five years with bigger drops in the S&P 500 since just 2000. The average intra-year decline during that time is not too far off at 16%.
Rather, what makes the investor pain in 2022 exceptional relates back to the direct impact of interest rates on all investments. Most of the time, bonds maintain their value or even increase when stocks fall, but not this year. The low starting level of interest rates has made the decline in prices particularly painful for bond investors.
For example, long term treasuries started the fourth quarter of 2021 with about a 2% yield, which hardly makes a dent in the decline in price of over 20% since October when I described cash as the only place to hide from short term spikes in interest rates. Similarly, the SPDR Bloomberg High Yield Bond ETF lost over 15% since last August when I wrote that junk bond yields of 3% were not worth the risk. Pardon the victory lap.
Today the outlook for high yield bonds depends largely on the path of the economy and defaults for the shakier companies that borrow in that market.
Long-term treasury yields in the neighborhood of 3.5% still look paltry especially compared to the tandem risks of inflation and continued rising rates.
It may look like those two risks are ebbing when gas and car prices inevitably fall. But many economists believe that somewhat higher long-term inflation or interest rates are natural consequences of deglobalization and tighter labor markets. Those trends could be here to stay a while.
David Born can be reached at firstname.lastname@example.org.