For the first time since we heard the name COVID-19, we now face the prospect of higher interest rates. The Federal Reserve announced last month that it would stop its purchases of Treasury and mortgage bonds by early March. While the Fed has not committed to raising its target federal funds rate, bond markets are pricing in three to four interest rate increases this year. These would be the first increases in more than three years.
While it’s hard to point a finger at the exact cause of recent stock market declines, these Fed announcements came as the S&P 500 neared correction territory, which means a decline of 10% from its recent high. Consider these steps to make the most of a possible rising interest rate environment.
Higher yields on cash and bonds. The good news for savers is that yields have increased for a broad category of bonds and other interest-earning investments. That being said, such benchmarks as the 10 year U.S. Treasury are still just yielding 1.9% annually. While that’s the highest rate we’ve seen since the onset of the pandemic, that’s still near historic lows. As recently as 2018 the same bond yielded over 3%. While even the best online savings accounts still pay only 0.5%, you could easily find rates over 2% a few years ago.
As long as your interest-earning investments are relatively short-term, you could benefit from higher rates. Savings accounts (assuming you move them to institutions with competitive rates) may soon pay more interest. Bond funds may also see higher yields. The caveat here is that bonds generally go down in value as interest rates increase. Longer term bonds are most affected by interest rate changes. To illustrate, imagine you bought a 30-year Treasury bond yielding 2.1%. If prevailing interest rates increase, then the value of that bond must go down to attract buyers on the resale market.
Growth stocks may suffer. Growth stocks are those companies that are priced higher than their peers given their current earnings. They trade at higher multiples because investors believe their future growth justifies a higher stock price.
Higher interest rates can impinge on growth stock performance in a few different ways. First, a quickly growing company may have greater need to borrow money to fund its operations. Second, if investors can get higher yields on safer assets such as Treasury bonds, this could make stocks in general comparatively less attractive. Finally, the rationale behind purchasing growth stocks is that they are companies with higher earnings in the future. As interest rates rise, promised earnings in the future become less valuable. We don’t know that value will continue to outperform growth as it did last month, but it would be wise to not focus your portfolio exclusively on growth stocks
Lock in rates while you can. While savers benefit from increased interest rates, borrowers do not. If you have a mortgage or other significant loan, take steps to lock in today’s low rates over the long-term. While that 3.75% rate on a 30 year mortgage may not sound good in the context of the last two years, it’s possible in the future you will look back grateful that you took steps today to borrow at a low, fixed rate.
David Gardner is a certified financial planner professional at Mercer Advisors practicing in Boulder County. The opinions expressed by the author are his own and are not intended to serve as specific financial, accounting, or tax advice. They reflect the judgment of the author as of the date of publication and are subject to change.