How To Invest in a Higher Interest Rate Environment

Updates from the Federal Reserves Meeting and its impact

Hell must have frozen over.

Jerome Powell, Head of the Federal Reserve, has finally acknowledged inflation is a problem. And as a result, is ending the easy money policies the Fed had implemented at the beginning of the pandemic.

What does that mean for you? Higher interest rates.

Along with a few other actions that impact the economy.

What Changes the Fed Signaled

The Federal Reserve had been purchasing $120 billion worth of bonds every month since the pandemic began. A little while back they announced they would begin tapering their bond purchases (i.e. slowly buying less than $120 billion worth each month) so that by summer 2022 the policy would end.

Yesterday they signaled the tapering would accelerate. The Fed will be buying $60 billion of bonds each month starting in January. The tapering will (likely) be complete by early spring.

After this, the Fed will start to raise interest rates. (It would be financially insane to raise rates before the bond purchasing is completely tapered off.)

Most people expected one rate hike in 2022, likely sometime in the Fall. Now, three rate hikes are expected in 2022.

It is also expected that there will be two rate hikes in both 2023 and 2024, but I wouldn’t bet my house on it. We need to get through half of 2022 before getting a clear forecast for 2023 and 2024.

One thing of note, the stock market was up big yesterday after Powell’s announcement — because there is now a road map for the year ahead. Markets don't like uncertainty. Now they know what to expect.

Jim Caron, from Morgan Stanley, said it best,

…the known unknown becomes a known known….the uncertainty is removed from the market. From an equity perspective, now they just have to focus on earnings, margins and growth.

How to Invest

Different sectors benefit from different interest rate levels.

The financial sector normally benefits from higher interest rates. This can include banks and insurance companies. Banks can earn more from the spread between what the interest they pay and the interest they earn. Higher rates also signal a stronger economy, which means borrowers have an easier time making loan payments to banks. Insurance companies have a direct relationship with interest rates, as higher rates provide them with higher returns for their bond investments.

As a twist, most bank stocks were down yesterday (12/15). This is because the Fed’s announcement boosted short-term rates more than long-term rates, causing the spread to narrow, for the time being.

Consumer staples also tend to do well in high-interest rate environments. Think of your old, established companies such as Coca-Cola, Johnson & Johnson, and Procter & Gamble.

Technology stocks, usually considered high growth, do better in low-interest environments. This is because they usually have high debt levels compared to their revenue. Lower interest rates = cheaper debt. That's attractive to investors.

During the pandemic, with low-interest rates, technology stocks have flourished. In recent weeks, they have stumbled — some of that can be attributed to the expectation of rising interest rates and some to the fact that investors sold off before the end of the fiscal year for tax reasons/portfolio rebalancing. And because stocks can’t go straight up forever.

Just because interest rates are slowly rising doesn't mean tech will no longer do well. It may still outperform the market — it's just that historically, higher rates aren't as friendly for the industry.

Reactions Around the Economy

Of course, after the announcement, everyone had their two cents. Some believed the actions were too aggressive, while others believed they weren’t aggressive enough.

From former Federal Reserve Board Governor Frederic Mishkin:

I think the Fed is behind the curve…The reality is that inflation is much higher than they anticipated. It’s more permanent than they anticipated…I think it’s actually a mistake to not be preemptive at this particular stage.

Chris Rupkey, chief economist at FWDBONDS:

“They had to increase the tempo because all of a sudden Fed officials are looking for three rate hikes in 2022 up from just one hike (barely) in 2022 when they made their last forecasts at the September meeting. What a difference three months make; inflation is no longer transient.

While these two were surprised by the lack of action, plenty of others were surprised to hear there will likely be three rate hikes in 2022. Some believe the best strategy for the economy is for the Fed’s easy money policies to continue.

Mark Cabana, from Bank of America,

The taper acceleration was expected. But what’s really hawkish is the dot plot and how the economic projection shifted...We thought they would only have two hikes next year based on commentary that was being said ahead of the meeting.

No matter where one stands on the issue, the economic landscape is changing. As a result, investing situations need to be reexamined and possibly updated.