How to Invest for Fall Rate Hikes by the Fed
The probability the Fed raises interest rates by 25 basis points this week is now greater than 90%.
The Federal Reserve held its benchmark interest rate at its July 28-29 meeting amid moderating geopolitical tensions and easing upward pressure on energy prices. But a re-escalating conflict in the Middle East, as well as a tariff war between the U.S. and Canada, have inflation expectations rising again.
And a rate hike is coming, probably as soon as this week's September Fed meeting.
The Fed held the target range for the federal funds rate at 3.50% to 3.75% in July, though there was a historic level of dissent from the decision. Multiple voting members of the Federal Open Market Committee (FOMC) expressed ongoing concern with price stability.
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Details of the August Consumer Price Index (CPI) report appear to validate these concerns.
Meanwhile, a blowout August jobs report shows the labor market is more than stable, and the Bureau of Economic Analysis reported better-than-expected second-quarter GDP growth.
As of September 14, CMEFedWatch – which tracks the implied probability of Fed moves based on 30-day fed funds futures prices– showed a 90.1% probability the Fed will raise by 25 basis points, or 0.25%, on Wednesday.
Indeed, price stability is the primary concern for Fed Chair Kevin Warsh.
Despite continuing pressure from President Donald Trump for lower interest rates, the target range for the fed funds rate is likely headed higher. So, what would higher interest rates mean for investors?
Let's break it down.
The Fed (usually) doesn't control long-term interest rates
The Fed's primary monetary policy tool is the federal funds rate – the interest rate at which commercial banks lend excess reserves to one another overnight.
When the Fed adjusts the target range for the fed funds rate, effects ripple across banks and through the economy.
The prime rate, which banks charge their most creditworthy customers, is closely tied to the fed funds rate. And most other loans – credit cards, small business loans, etc. – are priced as a spread above prime.
The Fed can also influence long-term interest rates by buying or selling longer-dated bonds, a strategy known as quantitative easing. But this is less common and generally reserved for emergency conditions, as in the 2008-09 Global Financial Crisis and again during COVID in 2020–21.
And Warsh has said reducing the size of the Fed's balance sheet is another priority, in support of his long-term monetary policy. So no significant bond-buying is expected this year.
What higher interest rates mean for bonds, savings accounts and other income investments
The expectation for policymakers is that higher short-term interest rates will lead to a flattening yield curve – short-term yields rise while long-term yields fall.
This typically happens because higher rates harness inflation expectations, pushing down long-term yields.
As a result, we can expect savings accounts, money market funds and Treasury bills to offer slightly lower yields.
And longer-term bonds, with maturities of 10 years to 30 years – may become marginally less attractive, potentially offering lower yields.
One important note: We probably won't see much of an effect on fixed-rate mortgages, as these tend to track longer-term interest rates.
What higher interest rates mean for stocks
All else being equal, a more accommodative Fed is generally good for the stock market. At the same time, higher interest rates aren't necessarily bad news.
Lower interest rates stimulate economic growth, which boosts corporate earnings; reduce borrowing costs, which improves profit margins; and make stocks more attractive relative to fixed-income alternatives.
An investor might be content to sit in a money market fund yielding 5%. But if that yield drops to 3% or lower, they might be more inclined to take risk in the stock market in search of better returns.
As rates fall, money tends to flow into equities.
As for the impact of higher interest rates on stocks, a lot depends on the prevailing environment. Right now, economic growth is solid, and corporate earnings growth is strong.
Stocks are likely to be volatile in the short term. But, over the long term, they'll adjust to higher interest rates.
Which sectors benefit most from higher interest rates?
In a rising-interest-rate environment, financial stocks and energy stocks are likely to do well.
Financials will benefit from their ability to ask more for the money they lend vs what they spend for the money they borrow, thus boosting net interest income. Oil and gas producers are enjoying higher prices for their output.
Growth stocks – particularly tech, small-caps and other companies dependent on expectations of future earnings – tend to suffer first. This happens for two reasons.
Capital is more expensive, and young, fast-growing companies often rely on external funding. Higher interest rates raise their cost of capital.
Then there's the valuation math. Higher interest rates reduce the present value of future profits, which trims valuations for companies with long-term earnings horizons.
Tech stocks and small-cap stocks, as well as other high-growth sectors may face initial headwinds when the Fed starts raising interest rates again.
At the same time, interest rates aren't the only factor to consider when it comes to buying stocks.
The Fed typically raises rates aggressively when economic conditions are firm. So stocks can survive and thrive overall.
Bottom line: Rate hikes are coming, and certain sectors may benefit. But stay diversified, manage your risk and don't blindly chase momentum.
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