Analysts expect the Federal Reserve to hike interest rates at least seven times in 2022. But even at this pace, interest rates should remain pretty low by historical standards for the foreseeable future.
Let’s take a closer look at how low interest rates may impact your investments, and how you should be thinking about your asset allocation given the current low-rate environment.
Are We Still in a Low-Rate Environment?
Fed officials haven’t been shy about telling the world that they plan to keep raising interest rates for a while. The Fed has indicated that 25 basis point hikes—that’s an increase of one quarter of one percent—are likely at each FOMC meeting for the rest of 2022. They could even do a 50 basis point increase.
“We will take the necessary steps to ensure a return to price stability,” said Fed chair Jerome Powell in a recent speech. “In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
That raises the question: Will we still be a low-rate environment by the end of 2022? A low-interest rate market is typically understood to be when the federal funds rate is below the historical average.
For the period from 1971 to the present, the historical average rate is 5.47%—although rates have been close to zero more than half the time since the beginning of the Great Recession.
The first Fed rate hike of the current cycle in March 2022 set the fed funds rate at 0.25% to 0.50%. If the Fed raises rates 25 basis points seven times in total in 2022, that would put fed funds at 1.75% to 2.00% by the end of the year—well below the historical average.
How Do Interest Rates Impact Your Investments?
Directly or indirectly, the fed funds rate influences the performance of every asset class, making it a key factor to understand as you adjust your investment strategy and rebalance your portfolio.
Interest Rates and Bonds
Bonds and interest rates have an inverse relationship. When interest rates rise, bond prices fall. Here’s why that happens: After an interest rate increase, newly issued bonds pay higher coupon rates, while existing bonds that were issued in a lower rate environment will offer lower coupon rates and be worth less.
It’s important to note that bonds with shorter maturities are less sensitive to changes in interest rates than those with a longer time to maturity. That’s because bonds with longer terms lock up your money for a greater amount of time.
Read more: Why Own Bonds When Yields Are So Low?
Stocks and Interest Rates
While bond prices are directly affected by interest rates, the relationship between interest rates and stock prices is less clear cut.
When interest rates rise, it becomes more expensive for public companies to borrow money to fund their operations. Higher rates mean companies may borrow less to fund growth. Meanwhile, lower spending by consumers and businesses could have a negative effect on revenue.
On the other hand, the Fed tends to raise rates when the economy is growing—and a growing economy fuels revenue expansion and higher stock prices. Looking at stocks, the impact of rising rates depends considerably on a company’s individual circumstances.
Looking at how interest rates affect the stock market as a whole, higher rates don’t necessarily dampen the stock market. Dow Jones Market Data analyzed the five most recent rate hike cycles, and they found that the three leading stock market indexes only declined during one rate hike cycle.
How to Invest in a Low-Rate Market
Asset allocation is not a one-and-done game. You need to take an active approach and respond to market conditions in order to help your portfolio grow.
Even in a low-rate environment, an allocation to bonds can insulate a portfolio against risk. When the market is running hot, there’s always the looming threat of stocks becoming over-valued, and the market could tumble.
A more risk-averse investor may want to maintain or even increase their allocation to fixed income to insulate against risk, while those with a greater risk appetite may want to increase the share of risky assets in pursuit of gain.
Own Bonds Even When Interest Rates Are Low
Fixed income plays the role of a shock absorber in a well diversified portfolio. Your allocation depends upon your risk tolerance, but it’s important to keep in mind that bonds give your portfolio stability.
When rates are low, investors may be tempted to reduce their allocation to bonds and put more of their money into stocks to chase higher returns. But if you go too far down this road, you could put your portfolio over the risk level dictated by a well-designed investment plan.
Diversify your fixed income portfolio
Low interest rates can be a bummer for older investors who depend on bonds for stability and income. Adding more stocks may not be a practical response, as this would expose them to more risk than they can tolerate.
If you want to increase income, consider replacing some investment-grade bonds with high-yield or emerging market options. Corporate bonds of lower credit quality offer a higher payout due to the increased risk. Emerging market bonds can also offer a higher payout.
Municipal bonds are another good option, as the income from munis is not taxed. Shorter-term bonds can serve as an anchor to the fixed income allocation, offering greater protection of principle. Shorter-term bonds also provide more protection for investors since longer-term issues lose more of their value when interest rates rise.
Increase Your Equity Allocation
Increasing the amount of money you invest in stocks makes sense in a low interest environment since equities are likely to generate higher returns. However, it’s vital to keep your risk tolerance and investment time horizon in mind.
Younger investors can afford to have a much larger percentage of their portfolio in equities. Target date funds, which rebalance their asset allocations over time to reduce risk as retirement approaches, often put younger investors almost entirely in stocks during low interest rate periods.
Investors who are closer to retirement might increase their allocation to stocks only slightly as they will have less time to recoup any potential losses. For investors who depend on fixed income investments to generate cash flow, dividend stocks can be a good choice in this environment since they both generate an income stream and offer the potential for appreciation.
Invest in Real Assets
Real assets are more than just real estate. They also include things like commodities, precious metals and other tangible assets.
The good thing about real assets is that they can add extra diversification to a portfolio since their correlation to stocks and bonds can be low. Moreover, they can also offer a potential hedge against inflation. Real estate also offers the potential to produce income.
While investing in real assets may sound daunting, it’s easier than ever thanks to mutual funds, exchange-traded funds (ETFs) and real estate investment trusts (REITs). These types of funds are simple to include in your portfolio, and offer exposure to real assets without direct investment.
Take Advantage of Low Interest Rates to Borrow and Reinvest
For investors with a longer time horizon and greater appetite for risk, a low interest rate environment offers a good opportunity to make use of that margin account.
First, a word of caution: Borrowing money to buy investments is always a risky proposition. Leverage amplifies returns and also amplifies losses.
Experienced investors might borrow money at a low rate and invest it in higher yielding securities. The profit is the difference between the higher return and lower return plus borrowing cost. Just keep a wary eye on the high risks that come with leverage.
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The Final Word on Low Rates
In every type of market, there are strategies that can help you seek to maximize returns while mitigating risk. It’s vital to be clear about your risk tolerance, expectations for return, and ability to bear losses.
Before making big changes in your portfolio, it’s always wise to speak to a financial advisor. Successful investors understand the importance of discipline and sticking to their investment plan even as they respond to changes in the interest rate environment and financial markets.