You may have seen media headlines this past year about how interest rates have gone up again and how stocks are tumbling. The interest rate hikes that the Federal Reserve has been using to combat inflation have led to pain in the stock market.
If you’re an investor or interested in building a portfolio, it’s important to understand how rate hikes impact the stock market and your investments.
Key Takeaways
- After the most recent rate hike by the Fed, we have now seen ten consecutive rate hikes since March 2022.
- When interest rates go up, consumer demand decreases, which leads to companies reporting lower earnings.
- When inflation is high, the cost of doing business increases for most companies. Investors become concerned about how stocks will perform in the future, so they start selling off their investments.
The String of Rate Hikes
Whenever the Fed raises interest rates by 50 or 75 basis points, the stock market usually reacts negatively to the news immediately. For example, by the end of business on September 26, 2022 – a few days after the Fed raised rates by 75 basis points – the S&P 500 hit a closing low for 2022. The Dow Jones Industrial Average fell into a bear market. At that point last year, every U.S. stock market index was in a bear market as fears of a global recession loomed large.
And since then, five more rate hikes have followed. The most recent rate increase happened earlier this month and marked the third consecutive rate hike of 25 basis points.
Every rate hike in 2022 in 2023 immediately impacted the stock market. Let’s look at how interest rate hikes affect stocks and the logic behind this so that you better understand what’s happening right now.
Why Did Interest Rates Rise Again?
Federal Reserve Chair Jerome Powell has made it clear since last year that the central bank will continue to raise rates until the battle against rising inflation is complete. Powell has said there is no painless way to fight inflation, though the Fed’s efforts are clearly having an impact, as inflation has dropped from its peak of 9.1% last June to under 5% in April 2023.
As long as rate hikes continue, stocks could continue to tumble as the rest of the economy also slows down. Luckily, the Fed has signaled that its May rate increase may be the last rate hike we see in 2023. Further rate hikes would have likely led to further losses in the stock market for investors who have already had to deal with market volatility for over a year.
Interest rate increases may stop for now as the balance in the economy is slowly restored. And while there was a point in 2022 when even Powell said a soft landing was unlikely, some experts now think it could happen. Other experts point to the first quarter’s shrinking real GDP growth as a signal a recession will be called later this year.
How Do Interest Rate Hikes Affect Stocks?
Whenever there’s an announcement of a rate hike, we should expect some volatility in the stock market. The most recent rate hike led to the S&P 500 dropping 0.7% at the market close. The DJI dropped 200 points or 0.8%. The tech-heavy Nasdaq Composite saw a dip of 0.46%.
Still, this was a pretty mild drop compared to the hits the market took during the fall of last year. In September 2022 – the day the Fed announced a 75 basis point increase to the fed funds rate – all three of the above indexes dropped at least 1.7%.
During that stock market drop, stocks in travel and entertainment fell the most. Of the 20 stocks in the S&P 500 that slid the most, 18 were a part of this sector since this is one area that gets hit particularly hard during an economic slowdown. Consumers are less likely to spend money on travel and entertainment – less essential commodities – when they fear a recession is looming.
The Fed left its options open for June after the May announcement. It’s difficult to predict right now if rate cuts are in the cards soon. More bad news could be on the way as some experts continue to anticipate a recession.
Why Do Interest Rate Hikes Affect Stocks?
The Fed raises rates to cool down spiking inflation. Higher rates mean the economy won’t be as strong. But why is that? The fed funds rate impacts the rate at which banks borrow and lend each other money overnight. Banks must meet reserve requirements related to how much cash they keep on hand, so a higher fed funds rate encourages banks to save and borrow less.
In response to a rate hike, banks will typically try to raise yields on savings products to incentivize consumers to deposit their money with the bank. They’ll also make short-term borrowing more expensive.
Variable interest rates, like the rates for credit cards, move in tandem with the fed funds rate. This is another downward pressure on consumer discretionary spending.
A rate hike is concerning news to investors because it typically signals companies will start to report lower earnings as consumer spending goes down.
This uncertainty naturally leads to many people selling off their stocks and holding more money in cash. This begins a vicious cycle that doesn’t stop until we reach “the bottom” and things start looking up. Uncertainty and fear alone are enough to lead to irrational sell-offs. When investors see their peers selling stock, they may join simply out of fear.
Since the stock market is forward-looking, investors anticipate lower earnings in the future since the cost of borrowing money is increasing. The feeling is that consumer demand will decline as rates go up.
People could also sell off their stocks to have personal money saved up in case of a layoff or other disaster, as it’s likely that each rate hike could be the trigger that puts the economy into a recession. The entire economy suffers when we’re in a recession, and job losses are common.
Are All Stocks Impacted Equally By Rate Hikes?
Interest rate hikes mean that borrowing money costs more, so there’s a strong likelihood that consumers will buy fewer things and borrow less money. It’s fair to conclude that discretionary spending will decrease as people will think twice before making extra purchases they don’t need. Consumers will put plans for vacations, purchasing high-ticket electronics, or moving into a bigger home on pause.
That said, while folks may hold off on splurging on a vacation or buying a new vehicle, people still need to eat and keep the lights on at home. So, some stocks are recession-proof as their companies sell necessities that are in demand during any economic cycle.
Companies in sectors like health care or consumer staples tend to fare better than most as the demand doesn’t decrease too much since people will still need their prescriptions filled up and food for their families. Utilities do well too, as we all need electricity. Discount retailers may also see their profits go unchanged (or increase) as people try to save money across all areas of spending.
It’s also worth noting that highly leveraged companies are impacted more by rate hikes since now the debt they have to pay comes with a higher cost. Companies with cash reserves are protected during these confusing times.
However, when there’s a stock market crash or sell-off, many companies are impacted even if they currently have strong financials or if they seem recession-proof. A stock market sell-off isn’t always a rational event as investors panic and make decisions based on fear.
How Can You Invest During Rate Hikes?
It can be difficult to adjust your portfolio and plan accordingly when there’s so much uncertainty in the economy. The biggest issue with rate hikes is that they could push us into a recession where the entire economy will suffer. Consequently, even well-balanced investment portfolios can drop in the short term.
There are many reasons why rate hikes affect the stock market, and it looks like we should expect more bad news in the coming weeks. This is why it’s often a good idea to update your portfolio’s allocation to ensure that you’re protected. There are ways to make your portfolio more defensive. Diversifying your holdings is often a good strategy.
The Bottom Line
As rates rise for hopefully the last time this month, it’s clear that the Fed will continue its rate hike campaign until the economy stabilizes. Hopefully, we’ve almost reached that point.
The Fed raises interest rates to combat high inflation in the economy. Higher rates impact the cost of short-term borrowing and encourage consumers to save more and pull their money out of riskier assets like the stock market.
There will be plenty of stock market volatility until everything shakes out. You must keep this in mind as you plan your investment strategy as the year ends. The only certain thing is that all eyes are on the Fed as investors and businesses try to figure out how to navigate this situation. We’ll also see how the previous rate hikes impacted consumer spending when publicly traded companies begin to release their next earnings reports in the coming months.
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