We’ve all heard about rising inflation, bailouts, and rising interest rates. It’s essential to understand what these terms mean and their effects.
Let's see how U.S. interest rates affect the American economy and global investments. And the effect of rising interest rates on asset classes and how to hedge your portfolio against it.
How U.S. Interest Rates Affect The U.S. Domestic Economy
Interest rates are the cost of borrowing. These costs impact the global economy and investment markets. When interest rates increase, the cost of loans and debt increases. This can be especially challenging for growing economies.
Why The Fed Raises Interest Rates
The Federal Reserve is the central bank of the United States responsible for monetary policies. The U.S. Federal Reserve has something called a target rate. The target rate is the ideal rate of inflation that the Fed needs to maintain in the economy. This inflation mandate is generally 2% for the U.S.
When inflation rises or growth slows down, the Fed adjusts interest rates to slow consumer spending or to stimulate the economy. If central banks want to stimulate local or global markets, they may lower interest rates. Similarly, when inflation comes in above expectation, they raise interest rates to control the inflation rate.
The Cost Of Borrowing
When interest rises in the United States, it affects the American economy in several ways. One of the most noticeable impacts is the cost of borrowing money. Higher interest raises the cost of borrowing. This makes it more expensive for businesses and individuals to take out loans or credit.
For example, suppose a company wants to invest in a new project that requires borrowing money. Higher interest means they must pay more on loans, reducing their potential profits. This may cause them to delay or cancel projects, leading to slower economic growth and reduced inflation.
The Value Of The U.S. Dollar
Another impact of rising interest is on the value of the U.S. dollar. If rates increase, foreign investors may find investing in U.S. assets better. Leading to an increase in demand for the U.S. dollar. This causes the dollar's value to appreciate against other currencies. Making U.S. exports more expensive and less competitive in the global market.
Think of the economy as a car. The interest rate is like the speedometer. When you step on the accelerator, the car will go faster, but it will also consume more fuel. It'll also create more pollution. The same is true for interest rates. Raising them may cause the economy to grow faster . But it can lead to inflation and higher debt levels.
Higher interest can also affect investments. Investors may prefer investing in assets that offer higher returns including bonds or stocks. This could make raising capital more challenging for some companies. Higher interest can also lead to a decline in the stock market since investors may become more cautious about investing in riskier assets.
How U.S. Interest Rates Impact Global Markets
When the U.S. Federal Reserve raises the U.S. interest rate, it affects the global economy and the economies of developing countries as well. Higher interest can increase the value of the U.S. dollar relative to other currencies. This makes U.S. investments more attractive to foreign investors. It also causes capital to flow into the U.S., causing other countries to tighten their credit.
When the U.S. dollar becomes more valuable, it can decrease commodity prices. This harms countries that export natural resources.
Higher rates can increase global interest rates for companies and governments. This decreases investment and slows economic growth. This can be hard for developing countries that borrow to stimulate growth.
Suppose a developing country borrows in U.S. dollars. Rising U.S. interest rates will increase the cost of repaying any debts. As a consequence, the country may need to look for financial help or bailouts from the IMF. For example, in the 1980s, many Latin American countries borrowed in U.S. dollars. But they struggled to repay their debt when U.S. interest rates increased. This led to a debt crisis that took many years to resolve and still has lasting impact.
Effects On Major Liquid Asset Classes
U.S. interest rates influence different asset classes in different ways. Knowing their effect on different assets is important for making better investment decisions.
- Commodities: Rising interest can hurt commodity prices.Falling rates can increase commodity demand.
- Credit: U.S. interest rates impact the cost of borrowing money. This affects credit markets. Higher interest create higher borrowing costs for companies and governments. This can lead to lower profits, defaults, and credit downgrades. Lower rates can stimulate credit markets, making borrowing cheaper and more accessible.
- Stocks: U.S. interest has a significant impact on the stock market. With low rates, borrowing becomes cheaper. Making it easier for companies to finance their operations and invest in growth. This leads to higher profits, dividends, and stock prices. But, when rates are high, borrowing becomes more expensive, which can lead to stock market dips.
- Bonds: U.S. interest rates inversely affect bond yields. Interest rate hikes cause the value of existing bonds to fall. This is because investors demand higher products to compensate for the increased risk. The value of bonds increases as interest rates fall. And investors have to accept lower yields than those available in other markets.
- Real Estate: U.S. interest has a significant impact on real estate prices. When interest rates are low, borrowing becomes cheaper. Making it easier for homebuyers to get mortgages, and increasing real estate prices. During opposite market swings, the cost of borrowing gets a massive rate hike. Causing an increase in mortgage rates, among others.
- Gold: Interest can affect the demand for gold inversely. The opportunity cost of holding gold is tied to interest, as investors can earn higher returns by investing in other assets. Conversely, when interest rates fall, the opportunity cost of holding gold decreases. Making it more attractive to investors seeking safe-haven investments.
- Crypto: U.S. interest rates can impact the demand for cryptocurrencies. Higher interest rates can increase the cost of borrowing to invest in cryptocurrencies, reducing the need. Conversely, lower interest rates can make borrowing cheaper. Leading to higher demand for cryptocurrencies.
- Inflation: U.S. interest rates have a significant impact on inflation. When interest rates are low, borrowing becomes cheaper, increasing the money supply in the economy and leading to higher inflation. Conversely, when central banks raise interest rates, borrowing becomes more expensive. Reducing the money supply in the economy and leading to lower inflation.
How To Hedge Your Portfolio Against Interest Rate Changes
High interest can have a significant impact on a portfolio's value. So, investors need to hedge their portfolios against rising U.S. interest rates. There are various ways to do this, each with unique advantages and disadvantages.
One method of hedging against interest rates is to invest in assets that are not affected by them. This includes assets like equities, real estate, and commodities. For example, suppose an investor holds a portfolio of stocks and real estate. This can make them less affected by rising interest rates. Compared to someone with a portfolio of bonds and fixed-income investments.
Floating Rate Securities
Another way to hedge is to invest in floating-rate securities, such as adjustable-rate bonds or loans, which have variable interest rates that adjust based on changes in market rates. This can help reduce the impact of rising rates on the portfolio's value.
For example, a company that issues a floating-rate bond will pay the investor a variable interest rate based on a benchmark rate, such as LIBOR (London Interbank Offered Rate). If the Federal Reserve or one of the many central banks chooses to raise interest rates, the bond's interest payments will increase, providing some protection against the rising rates.
Investing in inflation-protected securities is another way to hedge. These securities, such as Treasury Inflation-Protected Securities (TIPS), provide a return that adjusts for inflation. As interest rates rise, inflation typically follows suit and the value of the inflation-protected security increases.
For example, suppose an investor holds TIPS. In that case, the principal amount of the security will increase with inflation, and the investor will receive a fixed interest rate on the adjusted principal amount.
A more sophisticated method uses derivatives. Derivatives like interest rate swaps, options, and futures contracts. These financial instruments allow investors to take positions on interest rates.
Without actually buying or selling the underlying securities. For example, an investor could enter into an interest rate swap. This is an agreement between two parties to exchange cash flows based on different rates. The investor can protect against rising rates by receiving fixed payments for variable costs.
You can also choose to invest in foreign currencies. When U.S. interest rates rise, the U.S. dollar generally strengthens against other currencies. Investing in foreign currencies, such as the Euro or Japanese Yen, can protect the rising U.S. dollar. For example, if an investor holds a portfolio of Euro-denominated assets, they may enjoy the Euro's appreciation against the U.S. dollar.
Each method has advantages and disadvantages. And investors should consider their options before deciding on a hedging strategy. It is also important to note that hedging a portfolio against rising interest does not end risk. But can help reduce its sensitivity to interest rate changes.
The U.S. dollar is regarded as the most dominant currency in the world and plays a critical role in global economies. It serves as a medium of exchange, a store of value, and a unit of account for international trade and finance. The importance of the U.S. dollar in the global economy attributes to several factors. They include stability, liquidity, and reserve currency status.
Good financial planning includes planning for higher interest rates throughout your investment's lifetime. By understanding and considering the impact of interest rates on their portfolio, investors can make informed decisions about their investments and achieve their financial goals. As always, we recommend that you speak to your financial advisor before making an investment decision that could affect the volatility or profitability of your portfolio.