How does the US Fed interest rate affect investors?

Interest rates, whether they are rising or falling, are likely one of the most discussed subjects in the investment world.  You can hardly avoid interest rates. Flipping open any major newspaper or browsing expert views, you are highly likely to land on those two words somewhere. 

As much as it’s a widely covered topic, many investors may still be confused about the implications of rates on global markets, and more importantly their investments. So, what exactly are the impacts of rates on our money? 

Riding on a previous article that explores the role of the US Federal Reserve, in this article, we talk about how changes in interest rates may (or may not) have an impact on your investments. 

How do US Fed interest rates affect you?

Impact on bonds ‍

Interest rates and bond prices have an inverse relationship. This means that when interest rates rise, bond prices decrease and when interest rates go down, bond prices go up. This is commonly dubbed as the bond see-saw relationship.

This is because the income generated by a bond (through its coupon payments) determines its price. When prevailing interest rates rise, existing bonds become less valuable as their coupon payments are lower compared to newly-issued bonds available in the market. The prices of these older bonds decrease, and they would consequently be trading at a discount.

Conversely, when current interest rates fall, older bonds with higher interest rates increase in value. Investors holding these bonds can sell them in the secondary market at a premium.

For example, let’s say there’s a bond with a $1,000 face value that pays $50 annually, giving a fixed interest rate of 5%. It was issued when prevailing interest rates also stood at 5%. 

Now, if a year later, interest rates rise to 7%, investors can buy a new bond for $1,000 and be paid $70 per year for holding it. This means that the old bond, which pays only $50 per year, has to be worth less. The bond would be sold at a discount. 

On the other hand, imagine that interest rates decline to 1%. A new bond bought for $1,000 would only pay a $10 yearly return to bond investors. Consequently, the previous bond, which gave $50 annually, becomes appealing, making the market bid this up so it trades at a premium.

‍Read more: Why does the bond yield curve matter?

Impact on stock markets ‍

In theory, interest rates and the stock market move in opposite directions. High interest rates hurt stock prices in two ways. 

Firstly, when interest rates rise, it becomes more expensive for companies to borrow money. This leads to a decrease in share prices because higher borrowing costs reduce the available cash for companies to re-invest in their businesses and growth initiatives.

Secondly, higher interest rates also mean the discount rate increases in valuing future cash flows and ultimately, the valuation of a business, causing stock prices to fall. 

Conversely, when interest rates fall, the stock market generally experiences an upward trend as borrowing costs decrease and the present value of future cash flows increases. This is epitomised by a decade of low- and near-zero interest rates after the Global Financial Crisis. 

Some companies benefit from interest rate hikes. For example, banks can make more money when interest rates rise as they can charge higher interest when people borrow money from them. 

Impact on consumers‍

Changes in the federal funds rate impact other interest rates, including those for mortgages, car loans, and other consumer debts. Higher rates can make borrowing more expensive, impacting decisions related to big-ticket items like homes and cars. 

As rates go on an upward trend, investors should look at expected increases in expenditure from heightened rates and consider how to budget their cash reserves, or proactively look into short–term cash or money market funds to continue growing their cash. 

On an index level, stock and bond markets may react to such events and information like the announcement of economic prints, leading to volatility. While volatility is a common occurrence in the market, it’s important to know that short-term fluctuations in the index and your portfolio should not overshadow the significance of long-term goals. 

Given all these potential impacts, how can investors formulate a right investment strategy made for the long haul?

Time in the market, not timing the market

The Fed fund rates play a critical role in shaping US monetary policy, with the most recent mission to tamp down high inflation in the country. Rates also have a broad impact on various aspects, from determining rates offered on savings accounts and the cost of personal and company borrowing.

This begs the question - Should we react every time the Fed fund rates change?

Indeed, it is very tempting to bet on rates and other news flows, but chances are we rarely predict rate movements right. Even if we do, consistently making the right bets based on that prediction is an insurmountable challenge. This adds to the complexity of the market, which arises from the interplay of various factors, such as economic indicators, geopolitical events, company performance, and investor sentiment, to name a few. 

Staying invested is key to harnessing the long-term compounding power in investing.  By using a  dollar-cost averaging (DCA) strategy, investors can ride through cycles and take the emotions out of investing.

How does it work? Let’s say you had invested $500,000 in a broad market index from January 1970 to March 2023, your money would have grown at an annualised rate of around 8% to over $7.7 million. 

Remember that the period contains the early 1980s when the Fed funds rate peaked at close to 20% to combat double-digit inflation and also two rate hike cycles following the GFC and the COVID-19 pandemic.

The Endowus Flagship Portfolios are designed to give investors broad exposure to global markets in a strategic and passive asset allocation. This is opposed to a tactical — or short-term and opportunistic — allocation. 

Our allocation strategy for core portfolios such as the Flagship Portfolios means that we largely track the global indices over time. You can also DCA your money into globally diversified, intelligent, low-cost portfolios seamlessly with Endowus.