Rising interest rates are an important but often misunderstood part of investing. Basically, the central bank, the Federal Reserve in the case of the U.S., uses interest rates to help manage the pace of economic growth. Higher rates mean businesses are slightly less likely to invest, and consumers less likely to spend. Less investing and spending tend to cool the economy.
That may sound like a bad thing, but if inflation and growth get too strong, then a sharp recession on the other side can be even worse. So central banks use interest rates to keep the economy on an even keel, how successful they are at achieving that is a different issue, but steady growth by using interest rates to help manage the pace of the economy is the ideal. If you want to get technical, the Fed’s goals are specifically two percent inflation and maximum employment.
How interest rates work
Now, to use an example of how monetary policy works. Assume interest rates are at two percent. For "ACME Co.," building a new factory with a five percent return is a good idea for business since the return on the project is more than the interest rate to finance it — but if interest rates are at six percent, then that same project with a five percent return could be a money loser, with ACME paying more in interest than the project will produce.
So the factory is either not built or delayed until interest rates fall again, and economic growth cools a bit. In the same way, a consumer may be more likely to buy a new car if they can borrow at two percent — but if borrowing costs six percent, they may hold on to their current car a bit longer.
There are millions of projects or purchases out there that people will do for a given interest rate, but as rates rise, less of them become attractive, and economic activity is dialed back a bit. That’s the theory. So what does all this mean for the markets?
Here are some of the myths investors face in relation to the impact of interest rate policy…
Myth #1: You know when you’re in a rising rate environment
Looking back at charts it seems obvious when interest rates were rising and when they were falling. At the time, though, this wasn't true. Consider that after sharp rate cuts in 2009 in the U.K. the big question, for several years, was when the U.K. would raise rates again. Actually, they unexpectedly cut them in 2016 after Brexit.
Even within the U.S. rates have been tricky to forecast. Many expected rates to go up in 2012, 2013 or 2014 but it didn’t happen until 2015 and even then it didn’t occur until December of that year, later than many thought. Also, many times in history raising rates has been met with slowing economic growth. In the 1960s, 1970s and 1980s the Fed was raising rates until a recession hit and then within just a few months rates saw a sharp decline. So the notion that we can say with certainty that we are in a rising rate environment for the foreseeable future is always a little optimistic. This is especially true this time because the Fed has gone out of its way to emphasize data dependence in how it conducts monetary policy, thus if the economic data changes, so could the path for interest rates.
Myth #2: Rising rates are bad for bonds
Historically this just hasn’t been true. The book Invest with the Fed is a treasure trove of information here for those looking to dig deeper. As explained by British economist John-Maynard Keynes in the 1930s:
"We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees."
So if we’re looking at 10-year U.S. government bonds, which investors can get exposure to with an Exchange Traded Fund (ETF), we see that returns are essentially quite similar looking back over history from 1966 to 2013 whether rates went up or down. Returns to 10-year Treasuries have been a little over six percent a year, and bonds even appear to be lower risk investments when rates are rising.
In fact, the best returns for bonds come when rates don’t have any clear direction at all, then returns have historically approached nine percent. This makes sense as bonds are a generally defensive investment, and lack of economic drama, whether good or bad, can be helpful to bonds. So basically, the market does a reasonable job forecasting how interest rates may move in the future. Therefore, if the media and everyone else suspects we are in a rising rate environment, then that probability is reasonably well factored into markets. We shouldn’t expect to make major profits or losses with that sort of information.
Also, note that bonds have yielded a lot more historically than they do now. In past decades, yields on the 10-year Treasury often exceeded five percent — now they are just north of two percent. While the historical patterns could repeat the exact levels of yields, that's somewhat unlikely in the near future.
Myth #3: It doesn’t matter which bonds you hold as rates go up
Which sort of bonds you are holding can make a difference. Basically, you can deconstruct most bonds into two sources of risk: interest rate risk and credit risk. Firstly, exposure to interest rate risk is often called "duration matters," and historically, shorter duration bonds have done better as rates go up.
It’s a relatively good time to own one-month Treasury Bills as rates rise and they offer some of their best historical returns in periods of rising rates. (They’ve historically returned 5.6 percent in rising rate environments whereas their average return is closer to five percent.) Of course, it’s important to remember than yields are far lower today than in recent decades. One-month Treasury bonds yielded just under one percent a year as of July 2017, so a five percent return is improbable.
The second source of risk has to do with your chance and time horizon for getting paid back on your investment, which is typically referred to as credit risk. If your bond is not getting paid back for several years then, all else being equal, you are more subject to moves in interest rates. If your bond has a big risk of not getting paid back, then interest rates matter less. For example, if you own an ETF that owns a lot of emerging market debt, then you are probably more focused on economic conditions in Turkey, Brazil and Mexico (to name a few of the major emerging markets) than you are about interest rate shifts.
Equally, if you own high yield debt in the U.S. (often called junk bonds), then you are likely more concerned about the profitability of the companies issuing the high yield bonds than broader moves in interest rates. Of course, in both cases interest rates matter too, but credit risk gives you something else to consider.
Myth #4: Rising rates are terrible for stocks
They are two things to know about stocks in rising rate environments. Firstly, stocks have indeed historically fared worse as rates go up, but secondly (and importantly) returns are also still handily positive. So in the presence of tax and transaction costs, dumping stocks simply because rates are going up may not make sense.
The average return for stocks across all periods between 1966 and 2013 is about 10 percent a year, but when rates rise this figure has decreased to just under six percent, which is definitely not as good as it could be but is comparable with the returns on bonds over the same period and still nicely positive. There’s also no major indication that stocks are riskier as rates go up — rising rates mean that we should perhaps temper our expectations for U.S. stocks, but not dump them entirely based on interest rate moves.
The main point here is that there are a lot of inaccuracies around rising rates. Increasing rates and tighter monetary policy certainly isn’t terrible for bonds, nor does it mean doom for the stock market. History suggests that returns have historically been positive as rates rise, which should be good enough to help steadily grow your wealth. This is perhaps just another reason why a pretty stable and well-constructed buy-and-hold portfolio can be a good idea.