After two years of near-zero interest rates, the Federal Reserve’s aggressive policy pivot has changed the market outlook. How could it affect bonds, stocks and portfolios?
Since March, the Federal Reserve has been hiking interest rates to tame multidecade-high inflation—and today, its monetary-tightening efforts may be far from over. Morgan Stanley Research’s U.S. Economics team forecasts that the Fed’s preferred inflation gauge will decline from 6.6% in March, to 4.2% by year-end1—still more than double policymakers’ 2% target rate.2
As it tightens policy, the Fed is trying to strike a delicate balance to achieve a “soft landing” for the economy: Hiking rates too high, too quickly could tip an already cooling economy into recession. On the other hand, not raising them enough may perpetuate higher prices that have been weighing on consumers and companies.
In everyday terms, higher interest rates mean it is more expensive to borrow money, from mortgages to auto loans to credit cards. Businesses also pay more to borrow the money they need to grow their operations. That's why, in response to rising rates, both consumers and businesses tend to rein in their spending, which slows economic growth and eventually lowers the prices of goods and services.
The Fed is trying to strike a delicate balance to achieve a 'soft landing' for the economy.
With the Fed poised to continue rate hikes through the remainder of the year and potentially into next, here’s a breakdown of what policy-tightening typically means for the markets and how investors may want to think about their portfolios.
The Impact on Bonds
The Fed sets the federal funds rate, which is the interest rate commercial banks charge each other to borrow money for a very short term, usually overnight. Typically, when the federal funds rate rises, it pushes interest rates for other bonds higher as well. And when interest rates rise, bond prices tend to fall.
The effect isn’t the same across the board. A bond’s sensitivity to interest rate changes depends on various factors, including its maturity date and coupon. Generally, bonds with long maturities and low coupons are more sensitive to changes in interest rates.
For investors looking to sell a bond before it reaches maturity, a rise in rates may mean they need to sell at a discount to face value to compete with newer, higher yielding bonds coming to market. However, if you buy and hold individual bonds to maturity, rising interest rates may be less of a concern, as you’ll receive your full principal back at maturity, provided the issuer doesn’t default.
For investors whose primary objective is income, rising rates mean some fixed-income assets may offer attractive yields. Higher yields also tend to make bonds more attractive relative to riskier assets like stocks.
The Impact on Stocks
All else equal, rising rates tend to weigh on stock valuations, as they can drag on corporate profits and growth potential. This effect often plays out in anticipation of Fed action. As investors saw during the first half of the year, stocks fell from their peaks as the Fed was just beginning its rate hike campaign. Still, different areas of the market may react differently:
- Growth stocks: When interest rates are trending higher, it can clip the wings of pricey growth stocks, whose valuations are predicated on future returns. When rates go up, it instantly raises the bar on far-out profits needed to justify today's stock prices.
- Dividend payers: With bonds now offering investors potentially higher coupon rates and less risk, dividend payers may need to increase their yield to compete. Higher interest rates can also pressure corporate profitability and, thus, make it harder to pay dividends, particularly for heavily-indebted companies.
- Financials: The financial sector is one area where higher interest rates may serve as a tailwind since lenders can potentially earn more on loans. Historically, banks and financial institutions have outperformed the S&P 500 during periods of rising rates.
Higher yields also tend to make bonds more attractive relative to riskier assets like stocks.
Strategies for a Rising-Rate Environment
Against a backdrop of persistent inflation, geopolitical turmoil and market volatility, investors may feel like they are navigating unfamiliar waters as the Fed aggressively tightens policy. Some strategies you may want to consider in consultation with your Financial Advisor:
- Strategic bond investment. For many investors, fixed income remains an important part of a well-diversified portfolio. Bond laddering is one way to control the amount of exposure investors have to rising rates, while diversifying bond holdings.
- An actively managed strategy. Benchmark equity indices like the S&P 500 have become dominated by a handful of mega-cap growth stocks, creating concentration risk for investors whose portfolios are heavily allocated to passive index funds. Actively managed funds are designed to outperform market benchmarks.
- The importance of diversification. Diversification can be essential to help smooth the ride for investors in turbulent markets. Consider the benefits of a diversified portfolio that’s balanced across sector, region and market capitalization.
As the Fed adjusts its policy to manage economic challenges, your Morgan Stanley Financial Advisor can help you stay on track toward your long-term financial goals. Connect with your Financial Advisor to discuss what strategies make sense for you in today’s market.
Questions to Ask Your Morgan Stanley Financial Advisor:
- How has my portfolio fared amid rising interest rates this year?
- In a rising-rate environment, what investment strategies will help keep me on track toward my financial goals?