Whether you like it or not, interest rates are rising once more. This article will discuss how to invest and profit in a rising interest rate environment.
I’m in the camp that interest rates will stay low for years to come because of the following reasons:
- Information efficiency
- Economic slack
- Contained inflation
- Coordinated Central Banks
- The growth of other countries such as China and India and their continued purchasing of US debt
- The growing perception that US dollar denominated assets are the safest assets in the world
- A 35+ year trend of declining rates is telling us we’re more adept at managing inflation with each new cycle that passes
However, there will be points in time where investors will face a rising interest rate environment. After all, the Fed Funds Rate (FFR) is currently at 0% – 0.25% and inflation is picking up post-pandemic. The 10-year yield bottomed at 0.51% in late 2020 and has since climbed over 1.3% at the time of this post.
With the S&P 500 at all-time highs and the U.S. national median home price also at new highs, inflation is clearly on the horizon. Therefore, investors need to shift their thoughts on how to invest and profit in a rising interest rate environment.
History Of The Fed Funds Rate And 10-Year Bond Yield
Before we discuss how to invest and profit in a rising interest rate environment, it’s good to understand the historical dynamics of the Fed Funds Rate and the 10-year bond yield. Please study this chart below.
As you can see from the chart, I wasn’t lying when I said interest rates have been coming down for over 30 years. The primary goals of the Federal Reserve are to contain inflation, promote orderly growth, and provide maximum employment.
The Fed usually assigns an inflation target, which currently stands at 2%, and adjusts interest rates, prints money, or buys back debt to reach such a target.
Since about 1984, inflation rates (green) have hovered at a manageable 1-6%, with a downward trend. As a result, the 10-year Treasury and the Fed Funds rate have followed lower as well.
When money is cheap, people tend to borrow, invest, and spend more. This causes inflationary pressure. But based on how inflation has been acting, rates are in their appropriate place.
Another thing to notice in the chart is how the Fed Funds rate (red) is much more volatile than the 10-year treasury yield (blue). The Fed Funds rate is controlled by a committee of people from around the nation. The 10-year yield is dictated by the Treasury bond market.
Loosening Correlation Between FFR And 10-Year Yield
There is a good correlation between the two, as is evident in the early 1990s. But notice how the correlation starts to loosen since 2005. In other words, we could see a large increase in the Fed Funds rate at 25 bps each hike, and the 10-year yield (the market) may still stay relatively flat.
OK, now that we’ve got some historical perspective on inflation, the Fed Funds rate, and the 10-year Treasury yield, let’s look at how interest rates and the S&P 500 have correlated.
The interesting thing about this chart is that whenever there is a recession (grey columns), the Fed has cut interest rates to help spur economic growth and employment.
The Fed seems to OVER cut rates compared to the decline in the 10-year yield and therefore has to hurry up and raise rates five years later. The Fed also recently promised us it will allow inflation to rise above its target rate for longer to help ensure employment growth.
Meanwhile, stocks and real estate are all at record highs. Further, the current U.S. unemployment fell back down to 6.3% in January 2021 from a high of 14.7% in April 2020.
All factors point towards higher inflation. Too much inflation is bad for buyers of goods like housing, food, clothing. Inflation may be the biggest cause of war between the haves and the have-nots.
10-Year Pressuring The Fed To Hike
The 10-year yield’s move upward is telling us the Fed should start raising the Fed Funds Rate again to counteract inflation. In other words, the Fed is likely behind the curve at the moment.
Please realize the market determines the 10-year bond yield and a committee of people determines the Fed Funds Rate. They don’t move at exactly the same time or in the same magnitude. Just look at the Fed Funds Rate from 2004-2007. The move up was huge, yet the 10-year yield stayed relatively constant.
The 10-year yield is more important because it is a much stronger indicator for borrowing rates. Also, the good thing about the 10-year bond yield moving higher ahead of a Fed hike is that if and when the Fed does hike, the market will have already baked the hike in. Therefore, any negative reaction should be muted.
Let’s say you’re still convinced that borrowing rates are going to skyrocket. Doubtful, but a possibility nonetheless.
Let’s look at the losers and winners of a rising interest rate environment.
Losers In A Rising Interest Rate Environment
Here are the losers or underperforms at the margin.
High Yielders. As interest rates rise, existing yields look relatively less attractive. Let’s say investors have been buying a REIT or AT&T mainly for their 5.5% yield. If the 10-year yield rises from 2% to 6%, investors would logically sell the REIT and AT&T and buy a risk-free 10-year bond that provides a higher yield. Dividend stocks, REITs, Master Limited Partnerships, and Consumer Staples will likely underperform.
Highly Leveraged Firms: If you’ve got a lot of debt, your debt servicing cost goes up with higher rates. Your risk of default also goes up. As a result, investors will sell highly leveraged firms at the margin. REITs, utilities, and any sector that commands high ongoing capital expenditure will likely underperform.
Exporters: As interest rates rise, the value of the US dollar rises because more foreigners want to own USD denominated assets. You need to buy US dollars to buy US property, US stocks, US anything. An appreciating dollar will therefore hurt US companies who derive a large portion of their profits from the export market because their goods will be more expensive at the margin.
Individual Debtors: Those of you with credit card debt, floating rate mortgages, student loans, and future car loan borrowers will feel a bigger pinch. If you have refinanced your mortgage yet, do so now as 30-year fixed and 15-year fixed rate mortgages have lagged behind the rise in the 10-year bond yield so far.
Winners In A Rising Interest Rate Environment
In finance, everything is Yin Yang. The following are the relative winners in a rising interest rate environment.
Cash-Rich Companies. If a company has no debt and plenty of cash, it will be perceived as less risky. The interest income from its cash will go up, and investors may flock towards these companies for relative safety.
Having too much cash is not a good use of capital, so the longer-term fate of the company will partly depend on its capital efficiency. I’d look for companies trading at book value, or who have a huge percentage of their book value in cash.
Technology and Health Care. Technology and Health Care are the opposite of high-yielding companies. These companies tend to utilize their retained earnings for more growth.
In the past 13 rising-rate environments over the past 64 years, tech and health care sectors gained an average of 20% and 13%, respectively during the 12-month period following the first rate hike of each cycle. This compares favorably to an average 6.2% gain in the entire S&P 500.
Of course, a lot of the future performance in tech depends on where current valuations and expectations lie. Right now, technology stocks are extremely expensive and prone to a sell-off.
Brokerages. Brokerages, like Charles Schwab, earn interest income on un-invested cash in customer accounts. So when rates rise, they can invest this cash at higher rates. This is the crux of the big debate about Charles Schwab’s free roboadvisory service. The leading robo-advisors all balked that Charles Schwab really wasn’t free since they recommended 8-30% cash weightings, which Charles Schwab would then use to earn a revenue spread.
Perhaps Banks and Insurers. So long as there’s an upward-sloping yield curve, banks should benefit. That said, I just wrote that the Fed Funds Rate (short-term) could rise aggressively, and the 10-year yield (medium/long term) could stay flat. As a result, banks could see a decline in net interest margins.
Shorter-Term Duration and Floating Rate Funds. To reduce your portfolio’s sensitivity to rising interest rates you want to lower the average duration of your holdings. The Vanguard Short-Term Bond Fund (VCSH) is one such example where if you pull up the chart, you’ll see much more stability.
Another idea is to buy a bond fund that has coupon rates that float with the market rate. Luckily, we also have an ETF for such a fund called the iShares Floating Rate Fund (FLOT). Treasury Inflation Protected Securities (TIPS) are another less sexy way to invest.
Individual Savers And Retirees. Retirees on fixed incomes or prodigious savers should rejoice with higher interest and dividend incomes. Retirees can more confidently withdraw at a higher rate without the fear of running out of money before death.
Those of you following the Legacy retirement philosophy can also feel good knowing your estate may last longer for future generations and organizations.
Relatively speaking, cash becomes more valuable as other asset classes decline. Therefore, at the margin, it’s good to start building a larger cash hoard to not only earn higher rates, but have the fire power to buy equities in case of an upcoming sell-off.
Rising Interest Rates Can Be Positive For All
It’s important to differentiate between short-term moves with long-term implications. Rate hikes in the short-term may result in knee-jerk sell-offs in various sectors and stock market indices.
However, over the long-term, rate hikes should be viewed as positive because it means economic activity is accelerating. The demand for money goes up, hence, rates can rise to meet such increased demand.
Further, we must also assume the Federal Reserve is always trying to act in the best interest of the US economy. The Fed will only raise rates if they see excess signs of inflationary pressure.
There’s only inflationary pressure if employment is robust thanks to strong corporate profits and consumer demand. In such an environment, anybody who has a job and owns assets is doing well. The virtuous cycle continues until there’s too much exuberance.
The Fed wants to contain irrational exuberance that may ultimately lead to an asset bubble and a bursting of such bubble. Nobody wants social unrest, rising unemployment, and years of financial pain that follow during a recession.
The issue, of course, is short-term timing and disconnects.
Summary Of How To Invest And Profit In A Rising Interest Rate Environment
It is important investors put the recent 10-year bond yield increase into perspective. ~1.3% on the 10-year is still much lower than where it was in January 2020 at ~1.8%. And back then, the economy was booming.
Further, if the Fed does start raising the Fed Funds Rate, it will be in tiny increments of 0.25% spread out over a couple of years or so. Therefore, don’t panic. Interest rates are at still extremely low levels.
At the margin, here are my suggestions on what to do.
- Reduce / avoid adding on future debt
- Refinance to a longer-term duration mortgage to take advantage of a lower fixed rate for longer. Imagine locking in a 2.75% 30-year fixed and the 10-year yield hits 2.75%. You would essentially be living for free.
- Increase cash weighting to increase interest income and build a war chest for future investment opportunities.
- Reduce weighting in higher-yielding securities. Reassess holdings in debt-heavy, valuation-rich growth companies.
- Consider reducing overall exposure to risk assets
- Recalculate your net worth targets for retirement and your safe withdrawal rates in retirement
- Start mentally preparing for a sell-off, more volatility, or no more gains until earnings catch up and surpass the weight of higher interest rates.
- Finally, start enjoying life with your massive gains so far!
Appreciate Higher Interest Rates
Although it’s a little sad our investments may not be growing as quickly in, partially thanks to higher interest rates, we should also feel good about how much money we’ve made so far. I view any gains we received in 2020 and 2021 as gravy.
Further, I’m thankful higher interest rates help produce higher investment income. As someone who wants to get out of the rat race within the next year or so, the timing for marginally higher rates is good.
Despite the increase in the 10-year bond yield, it is highly unlikely the Federal Reserve will raise rates as quickly. The Fed is on our side. Therefore, we should probably continue to stay invested in this improving economy, despite the likelihood of another correction. I still don’t believe the 10-year bond yield will get back to pre-pandemic levels as some economists do.
At the same time, I’m on a mission to rebuild my cash hoard and seek better entry points in the stock market. I’m also more focused on looking for real estate opportunities because it is less volatile and will likely outperform stocks. Ironically, there could be an even greater rush to buy real estate if prospective buyers fear mortgage rates will start rapidly rising.
In a rising interest rate environment, please brace yourself for volatility to return. And if you haven’t maxed out your tax-advantageous retirement accounts or 529 plans, be prepared to have another opportunity.
Readers, how are you investing in a rising interest rate environment? Are you making any asset allocation changes?
Recommendation: If you have a financial advisor / money manager, it’s good to talk to them about how to invest in a rising interest rate environment. In fact, Personal Capital is running a promotion where if you sign up and link your accounts worth over $100,000, you can talk to a financial advisor for free to analyze your portfolio. The cost is usually $799, but it’s now free until end of March 2021. Sign up here and schedule a review after you link up your accounts.