What rate hikes mean to you

We can come up with a thousand reasons why markets fluctuate but ultimately, Tony Dwyer broke it down best:

Markets move in the direction of earnings.

What drives earnings? Economic Activity.

What drives economic activity? Money Availability.

What drives money availability? Fed Policy.

So, let’s remind ourselves of what the Fed’s policy is per their website:

Monetary policy in the United States comprises the Federal Reserve's actions and communications to promote maximum employment, stable prices, and moderate long-term interest rates--the economic goals the Congress has instructed the Federal Reserve to pursue.

The issue that everyone is aware of right now is the lack of stable prices. Inflation is at levels that we have not seen since the 1980’s.

The Consumer Price Index (CPI) relates to the daily cost of living. This serves as a measure of the total value of goods and services that we have bought over a specified period of time.

The Producer Price Index (PPI) provides us insight into the cost of producing consumer goods. This is important to us because when manufacturers are paying more to produce the goods, that increase in cost is ultimately based down to us, the consumers.

As these charts indicate, both metrics have seen significant increases in the past year:

We can debate why we are seeing such dramatic increases but what is more important is understanding how this impacts you, not only as a consumer, but as an investor.

How does the Fed fight this rampant inflation?

By eliminating their bond buying spree which reduces money movement and by raising interest rates. This makes it more difficult/expensive to borrow money.

It’s been over 3-years since the Federal Reserve last raised interest rates. But there is widespread consensus in the markets that the Fed will raise rates in March.

From a consumer perspective, raising interest rates affect your credit card rates, car loans, and mortgages. The 10-year Treasury yield serves as a benchmark for auto loans and mortgage rates. As the yield for the 10-year Treasury bonds rise, auto and mortgage rates typically follow suite.

The average rate on a 30-year fixed-rate mortgage is now around 3.55%, still low by historical standards but up nearly 0.8 percentage points year over year, according to Freddie Mac. 

These raising rates will force consumers to reconsider their purchases. You may have been eager to buy real estate when your interest rates were around 2.5-3%. But when that gets to 4-5%, you may reassess your decision as that monthly payment has increased.

One of the upsides to raising rates is eventually higher rates will be offered on savings accounts. Some of you may be familiar with high-yield savings accounts that offer a decent yield compared to the average savings account.

As the Fed raises rates, banks will increase the rates offered on these accounts. Just don’t expect them to raise those rates in a timely manner…

From an investors perspective, raising interest rates impact both stocks and bonds. When yields rise, bond prices fall. With stocks, rising rates make it more expensive for these companies to borrow money which ultimately eats into their profits.

When you hear, ‘the markets have already priced in X number of rate hikes’, that means investors have updated their discounted cash flows to include higher borrowing costs. This brings down company valuations and can lead to investors trimming their positions.

A stocks valuation is a reflection of their future expected earnings.

Also, when rates begin to rise, this can change an investors desire to buy stocks. If for example, the rates for bonds and certificate of deposits (CDs) begin to rise, more risk averse investors will diversify away from stocks into these instruments. This ultimately decreases the valuation of stocks.

Worth noting though that with inflation around 7%, you will still get a negative REAL return on these bonds/CDs paying around 2-3% interest.

But, as noted above, earnings drive markets. And what’s been masked behind the Russia/Ukraine tensions is the impressive earnings companies have been posting.

As of this week, according to LPL Research, 70% of the S&P 500 have reported and earnings growth is 9% above estimates. This is a sign that LPL’s 6-7% earnings forecast for 2022 may be conservative.

We are tracking to see 30% year-over-year earnings growth. In prior quarters, these YoY increases weren’t that impressive as we were comparing it to quarters that we were under lockdowns and production was limited.

That’s not the case now. Despite Omicron, labor shortages, inflation, etc., companies have been resilient. Good news for stocks!

Despite the endless headlines, no one knows for sure what the Fed will do. But it’s always important to take a step back and see how rising interest rates impact you as a consumer and an investor.

If you are a long-term investor, the immediate noise around rising rates shouldn’t bother you all that much. It will be interesting to see how the Fed is able to land a plane on such a short runway.

-        Kyle

Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual.