Interest rate fluctuations can send ripple effects throughout the economy. While the recent interest rate cuts are meant to support and stimulate current economic activity, it’s possible these effects could have an impact on stocks, bonds and other investments.
The Federal Reserve (Fed) has a dual mandate: to promote maximum employment and price stability. One of the ways they do this is through adjusting short-term interest rates.
If economic growth is lagging and unemployment is rising, the Fed can lower interest rates to make it cheaper to borrow, which should spur hiring, investing and consumer spending.
On the other hand, when the economy is growing quickly, the Fed may become concerned about inflation. In this case, the Fed can pump the breaks and raise interest rates to make borrowing more expensive and, in turn, dampen spending.
Reviewing the Fed's previous actions shows how these scenarios map out. For example, leading up to and during the financial crisis in 2007 and 2008, the Fed drastically lowered rates to help jump-start a flagging economy. Eight years later, rates were still hovering close to zero. As the economy strengthened, the Fed raised interest rates 9 times between 2015 and 2018.
More recently, the Fed cut interest rates 3 times in 2019 as the economy showed signs of slowing, twice in 2020 – to near zero again – to curb the economic effects of the coronavirus pandemic.1
Given the recent ups and downs, it’s important to understand how interest rate changes can affect the components of your investment portfolio.
Interest rates and bonds have an inverse relationship: When interest rates rise, bond prices fall, and vice versa. Newly issued bonds will have higher coupons after rates rise, making bonds with low coupons issued in the lower-rate environment worth less.
It’s helpful to understand the following three concepts regarding the bond and interest rate relationship.
Read our wealth management leaders’ outlook on bonds in 2021 and where opportunities may lie for investors.
In contrast to bonds, interest rate changes do not directly affect the stock market. However, Fed actions can have trickle-down effects that, in some cases, impact stock prices.
When the Fed raises interest rates, banks increase their rates for consumer loans. In theory, this means there’s less money available for consumer spending. Also, increased rates for business loans can sometimes cause companies to halt expansions and hires. Reduced consumer and business spending can both lower the value of a company’s stock.2
Still, there’s no guarantee that a rate hike will negatively impact stocks. Typically, rising interest rates occur during periods of economic strength. In this scenario, increased rates often coincide with a bull market. With a balance of stocks and bonds, your portfolio may be better positioned to maintain more stability despite an interest rate increase.
In addition to stocks and bonds, consider how rate changes might affect other elements in your portfolio.
In summary, when interest rates are lowered:
When interest rates rise:
Because interest rate fluctuations can affect investments in different ways, there is no single action you should take when they change.
Stay focused on your financial goals, stick to your plan, and work with your financial professional to construct a portfolio that is diversified enough to help weather any short-term effects of a rate change.
Learn more about building a diversified investment portfolio.