In December 2016 the Federal Open Market Committee (FOMC) raised interest rates for the first time in a year, and then raised them again in March 2017. Federal Reserve Chair Janet Yellen indicated that the Fed could raise interest rates even further later this year. But what do rate hikes mean for advisors, their clients and investment portfolios?
Do Portfolios Benefit from Rising Rates?
When interest rates increase, bond prices decrease. And while many analysts expect equities to suffer when interest rates go up – which is what many had predicted for markets in 2016 – these more recent rate hikes have not taken the wind out of the U.S. stock market's sails. Lately, it seems that when rates rise, the value of equities doesn't take a hit. But there's no telling how long this trend will last. (For more, see: Fed Increases Interest Rates at March Meeting.)
With that being said, recent stock market increases have come on the heels of speculation for increased spending and proposed tax cuts by the Trump administration. When there is a sudden increase or decrease in the market as a reaction to the current political, economic or civil state, a correction is often close behind. This is why it’s important for investors to consult with a financial advisor, make smart investment decisions and refrain from acting on impulse, regardless of whether their portfolio favors bonds or equities, or both.
What Are the Risks of Rising Rates?
Although advisors can’t predict what is going to happen in the stock market and how it will react to future interest rate hikes, they can take measures to ensure their clients benefit from rising interest rates while taking all potential risks into account. In a simplified example, let’s say a client is a balanced investor which usually means a portfolio is a 60/40 mix of equities and fixed-income investments (such as bonds).
In a declining interest rate environment, the asset allocation may be 60% fixed income and 40% equity to take advantage of rising bond prices. In a rising interest rate environment, the allocation can flip to 60% equities and 40% fixed income to benefit from bullish equities. The client’s risk tolerance always remains intact and slight adjustments are made to take advantage of stock market movements. (For more, see: The 4 Most Important Effects of Rising Interest Rates.)
What About Foreign Exchange?
A well diversified portfolio can hold both domestic as well as foreign investments, but how do rising interest rates affect foreign exchange? If $1 USD equals $1.35 Canadian dollars the U.S. dollar is stronger. This means it’s not a good time to exchange Canadian money into U.S. currency because Canadians will only receive $0.65 USD for every Canadian dollar exchanged. However, it would be a good time for Americans who want to invest in Canadian currency to take advantage of the foreign exchange while the dollar is strong.
When investing in foreign currency, the same basic investment principals apply – buy low and sell high. A strong U.S. dollar means it has a higher value compared to another currency – the U.S. dollar buys more of the other currency. This is the current case of the U.S. dollar versus the euro where $1 USD equals 0.94 euros. And rising interest rates can lead to a strengthening currency at home, but again these theories do not always pan out, as last time the Fed raised rates the U.S. dollar jumped while this most recent rate hike was followed by a slide.
When investing for long term goals, such as retirement, investors should always keep the bigger picture in mind and therefore short-term changes shouldn’t be as important. As long as the asset mix in your portfolio aligns with your investment objectives and you’re comfortable with the level of risk, there’s no need to constantly buy and sell. Trying to time the market, especially during uncertain political and economic times, is never a smart investment strategy. (For more, see: How Do Interest Rates Affect the Stock Market?)