How Interest Rates Impact Your Stocks

Federal Reserve Chair Jerome Powell will testify before Congress for two days this week.

The head of the U.S. central bank will attend hearings before the House of Representatives on Wednesday and the Senate on Thursday.

Twice a year, the Fed Chair delivers a report to officials that provides insight into the state of the U.S. economy, the labor situation, inflation, interest rates, and much more.

Now, keep in mind that the Federal Reserve is in charge of monetary policy.

In contrast, the Treasury Department and Congress determine fiscal policy (taxes, subsidies, and general control of the nation’s budget).

Monetary policy centers on the Fed’s dual mandate to improve the U.S. labor market and ensure price stability (controlling inflation) by using specific tools like interest rates and bond-purchasing programs.

The dual mandate is the reason the central bank’s focus on interest rates is so critical. When the Fed lowers interest rates, it aims to increase borrowing and spending by businesses and consumers. It also aims to generate more business activity and more hiring.

When the central bank raises interest rates, it is generally an action to reduce inflation and “cool off” the economy.

The focus right now is heavily on inflation. This morning, the government released the Consumer Price Index (CPI). You’ll likely hear more about the increase in consumer costs over the next 24 to 48 hours. Congress will probably have a lot of questions about inflation and its impact on the economy.

However, the Federal Reserve has already signaled that it will not raise interest rates in 2021. Instead, the Fed Chair has said the central bank is willing to let the U.S. economy overheat a little to generate more inflation.

But when a rate hike comes, it’s essential to understand what it means for your portfolio.

Today, I want to explain how higher interest rates (or even the speculation of higher interest rates) would affect your portfolio and what to do about it.

What the Fed Acts

The Fed Open Market Committee (FOMC) is the policy decision-making arm of the U.S. central bank. It has a small roster of decision makers.

Seven governors for the Federal Reserve Board and five Federal Reserve Bank presidents (from the 12 Fed banks across the country) set a specific target for the fed funds rate.

This fed funds rate (or discount rate) is the basis on which all U.S. lending and market activity operates. It is a rate at which deposit-holding banks can borrow and lend to each other overnight. The Fed will raise or lower that rate to influence the amount of money in the economy.

A rate cut increases the amount of money available. A rate hike reduces the amount of money. And when there is less money available, the cost to borrow that money goes up across the entire economy.

Why?

The fed funds rate, in turn, impacts the prime interest rate in banking.

This is the rate that large banks offer to the most trusted customers with the best credit scores. Think of a FICO score of 850 combined with a perfect payment history dating back to the 1980s. It’s tough to get the prime rate.

But that prime rate is the basis for all other forms of loans based on creditworthiness. So if the fed funds rate goes up, the prime interest rate increases, and thus the cost of interest on a credit card, auto loan, and other forms of credit also goes up.

But how does that impact the stock market?

Well, let’s look at how it impacts a company’s balance sheet.

Higher Rates, Higher Costs

Rising interest rates don’t have a direct impact on the stock market themselves. However, they do have a secondary effect that can impact prices, particularly from a psychological sentiment.

Remember that each time interest rates rise, so too does the cost of borrowing. This is because corporate America primarily funds its operations by selling debt. Of course, since 2009, corporate-grade bonds and junk bonds have seen steep declines in their interest rates as the Fed moved to keep that fed rate lower and lower.

Higher interest rates mean that companies need to spend more money paying back debt. Rising interest payments impact cash flow, which affects the price of a company’s stock.

But higher rates also impact consumer spending. Remember that consumers will need to pay higher interest costs on their credit cards, auto loans, and everything else they might buy with borrowed money. The same goes for business-to-business transactions. The bulk of purchases made through U.S. supply chains are done so on trade credit. When interest rates rise, trade credit can be restricted or prices might increase. Typically, higher costs in supply chains are passed on to consumers, who will also face greater interest payments on their purchases. 

As a result, if consumer purchases decline, this too can impact the bottom line of a company and thus its stock price.

What to Do

Remember, rising interest rates don’t negatively impact every class of stocks. For example, banks, mortgage companies, and insurance companies benefit from a rising interest rate environment.

It’s important right now that you consider the prospect of higher rates as a way to potentially diversify your portfolio from any rate shock that might come. Remember, it was just a few years ago that the Fed began that dreaded “Taper Tantrum” by increasing interest rates by just a tiny amount.

Now, with the prospect of similar shake-ups in sentiment, consider firms like Bank of America (BAC), Berkshire Hathaway (BRK.B), and U.S. Bancorp (USB). All three of these companies have a buy rating in the Green Zone on TradeSmith Finance. And all three are experiencing an uptrend in momentum as we await Jerome Powell’s testimony this week.

I’ll be back tomorrow to talk a bit more about inflation. Following this morning’s release of the Consumer Price Index, it’s essential to understand other ways to diversify your portfolio should this pace of inflation not be “transitory” in 2021 and beyond.