How To Invest And Profit In A Rising Interest Rate Environment

Learn how to invest and profit in a rising interest rate environment. If you do, you will invest better, make more money, and lose less money.

Even though we are in a rising interest rate environment, I’m in the camp that interest rates will stay low for years to come. I expect inflation and interest rates to fade over time again. Here’s why:

• 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

Despite inflation and rising interest rates being transitory, rising interest rate environments still happen. And when they do, investors need to better prepare. Profiting in a rising interest rate environment is harder as the easy money disappears.

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.

Low Interest Rates Can Create Bubbles In Asset Prices

When money is cheap, people tend to borrow, invest, and spend more. This causes inflationary pressure and lots of funny money gains. Suddenly, everybody thinks they are an investing genius when rates are near 0%.

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.

In a rising interest rate environment, it’s actually easier to generate more passive income. As a result, you may ironically be even more secure, even though your asset values are likely declining.

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 bond yield, let’s look at how interest rates and the S&P 500 have correlated.

How Interest Rates, Stocks And Recessions Are 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. As a result, it 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. This way, it helps ensure employment growth.

Meanwhile, stocks and real estate are all at record highs. Further, the current U.S. unemployment fell back down to 6% in March 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. The Fed’s easy monetary policy has created a lot of fuel for risk assets such as stocks and real estate.

Please realize the market determines the 10-year bond yield and a committee of seven governors 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 for mortgages. 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 underperformers in a rising interest rate environment. You either want to not hold these investments, sell, or short.

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 (tech and growth stocks in particular): 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.

More Winners In A Rising Interest Rate Environment

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. You want to hold, buy, or buy more of these positions.

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. Therefore, 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.

Tech and Health Care. Health Care is 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. Unfortunately, when valuations are expensive for tech stocks, they tend to get crushed the most when interest rates rise.

Financials Are Winners In A Rising Interest Rate Environment

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. Charles Schwab would use the cash to then earn a revenue spread.

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.

Financial Enthusiasts Are Winners Too

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. 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.

Personally, I love buying Treasury bonds when they are yielding over 4.5%.

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 now. Not only will you earn higher rates, you will also 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, which it is seeing. The key is whether the Fed will be able to raise interest rates less in the future as the markets do its job for them.

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. People buying growth stocks on margin at all-time highs need to be stamped out. For it 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.

The Yield Curve Today

In 2023, the yield curve is inverted. In fact, the yield curve is the most inverted since 1981! An inverted yield curve is a harbinger for a recession. As a result, all of us need to save more and be prepared for potential hard times.

We’ve had tremendous asset price appreciation since 2020, when the yield curve was upward sloping. However, the bear market returned in 2022, and asset prices will likely not go anywhere in 2023. Nobody knows for sure, but the U.S. economy is experiencing a hangover after a lot of excess.

Economic devastation is unlikely to occur, but it’s always good to be prepared. Personally, I think 2023 is actually the time to start buying some discounted stocks and real estate.

Over $150 billion in pent-up demand from China is looking to buy international assets. Some of that money will come to U.S. real estate. Further, interest rates and inflation are finally coming down. Hence, risk asset values might rebound.

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. ~1.6% on the 10-year is still 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 as debt becomes relatively more costly

• 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 3.5%. 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, especially after a huge bull run since 2009

• 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.

I’m on a mission to rebuild my cash hoard and invest in more high-yielding Treasury bonds. I’m seeking better entry points in the stock market. Further, I’m also focused on looking for real estate opportunities.

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.

Related: How To Make Lots Of Money During The Next Downturn

Best Way To Benefit From Rising Inflation

Although rising interest rates make buying property with a mortgage less affordable, real estate is one of the best asset classes to benefit from rising inflation. Inflation will help push up rents and property prices.

Real estate is a key part of the inflation metric. Therefore, if inflation is rising, so is real estate. If you can lock in a long-term fixed mortgage rate, over time, inflation will reduce your debt down.

If you don’t want to own rental properties or can’t afford to buy a physical rental property, take a look at my two favorite real estate crowdfunding platforms.

The Best Private Real Estate Investment Platforms

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eREITs. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified fund is the best way to gain risk-appropriate exposure.

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot of capital, you can build your own best-of-the-best real estate portfolio with CrowdStreet.

I’ve personally invested $810,000 in real estate crowdfunding across 18 projects. I want to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000. 

How To Invest And Profit In A Rising Interest Rate Environment Is a Financial Samurai original post.