Stocks When The Federal Reserve Raises Interest Rates
What is the typical pattern for stocks when the Federal Reserve raises interest rates? That is the question on many stock trader’s and investor’s minds, as Federal Reserve interest rate hikes appear increasingly likely during 2015. There is some angst among traders and investors that Federal Reserve interest rate hikes will cause a sharp stock market sell-off. While such concerns are warranted, it is important to understand the typical trading pattern that occurs in the stock market when the Federal Reserve implements interest rate hikes, so that a stock trading or investment portfolio can be properly managed.
Stock Market Reaction The Federal Reserve Raises Interest Rates
Keep in mind that the Federal Reserve raises interest rates when the economy is strengthening and inflation pressures start picking up. The Federal Reserve raises interest rates in an effort to slow down economic growth, so that the economy does not overheat and inflation does not spiral higher.
The initial stock
market reaction when the Federal Reserve starts raising interest rates is to sell-off, as the market tries to price in how higher interest rates will affect corporate earnings. Higher interest rates affect corporate earnings by raising the borrowing costs for companies, which puts pressure on their bottom line earnings. This is particularly true for companies that are highly leveraged with debt, such as Real Estate Investment Trusts (REITs).
The sell-off due to the initial Federal Reserve interest rate hikes is usually short-lived, as the economy continues to grow and companies continue to report growing earnings. The typical pattern that the stock market follows is an initial sell-off and then a rally for a year or two after the Federal Reserve starts to raise interest rates. The rally ends when the Federal Reserve raises interest rates too much and the yield term inverts (short term rates become higher than long-term rates), which sends the economy into a recession. Typically, when the Federal target rate reaches four percent, it is time to turn cautious and prepare for a recession and stock market decline. A bear market sell-off will typically take hold until the middle of a recession, at which point the next bull market rally will start.
What To Do When The Federal Reserve Raises Interest Rates?
What should a trader or investor do when Federal Reserve raises interest rates? The answer to that question depends upon your trading or investment horizon and how your portfolio is weighted among various asset classes.
If you are a trader, then the start of the interest rate increase cycle provides opportunities to profit from any stock market volatility that ensues. Going short stocks, buying puts on stocks or stock market indexes, or buying volatility Exchange Traded Funds (ETFs) are three ways to potentially profit from a stock market sell-off that might occur during the early stages of Federal Reserve interest rate hikes. Once the sell-off appears to have played out, a strong tradable long side opportunity will likely be available, as the stock market recovers from the initial shock of higher interest rates. Buying stocks, buying calls on stocks or stock market indexes, or shorting volatility Exchange Traded Funds (ETFs) are three ways to potentially profit from a stock market rally.
If you are an investor, then the start of the interest rate increase cycle provides an opportunity to evaluate how your portfolio is balanced for the later stages of an economic recovery and how to position your portfolio for the eventuality of a recession within a few years of the start of interest rate increases. If you trade a portion of your long-term stock investment portfolio, then think like a trader to take advantage of the increase in interest rates.
If you are a buy and hold investor, the Federal Reserve interest rate hikes during upcoming years are a non-event, with the exception of the fact that they may provide good buy in points to dollar-cost-average down on long stock positions. What the rate hikes will essentially mean is that the stock market will likely sell-off and provide buying opportunities, not just initially, but also in the long run, as rate hikes eventually lead to a recession, as the Federal Reserve seeks to choke off economic growth to keep a lid on inflation. If you are truly a long-term buy and hold investor that is planning on staying in the stock market for decades, the upcoming rate hikes will be non-events; just blips on long-term charts.
What To Do When The Federal Reserve Raises Interest Rates? Rebalance An Investment Portfolio
Whatever your investing philosophy is, the pending Federal Reserve interest rate hikes are a great time to take a step back and gauge whether your investment portfolio is too heavily weighted with stocks. Most investors have investment portfolios that are heavily over-weighted in stocks because when an individual investor thinks of investing money, they think stocks. With the Federal Reserve interest rate hikes likely to cause stock market turmoil over the short and long term, it is a good idea to assess whether some stock holdings should be shifted into other asset classes, such as fixed-income, real estate, and bonds.
Fixed income securities, such as Certificates of Deposit (CDs) will pay higher yields, as interest rates rise. A pick-up in inflation associated with stronger economic growth helps support higher real estate prices. Bonds should be avoided during the initial stages of the Federal Reserve’s increases in interest rates, since bonds are currently overvalued and are likely to revert to their mean value (drop in price) as interest rates are increased by the Federal Reserve. Once the Federal Reserve is well into their interest rate increases, it will be time to consider investing in bonds that have reached fair values and pay higher yields in the higher interest rate environment.
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