For much of the beginning of this year there has been a lot of chatter surrounding inflation, interest rates and the role of The Federal Reserve (The Fed) in bringing stability to prices.
The fact of the matter is The Federal Reserve holds a lot of power when it comes to influencing the economy, and by proxy, the performance of stocks, bonds and other investments.
With that in mind, it’s important to be aware of how changes to domestic monetary policy could impact your portfolio and the actions you can take to help safeguard your investments.
How does The Federal Reserve impact the economy?
The role of The Fed is to determine monetary policy to help encourage employment, manage inflation and control interest rates, all in an effort to drive sustainable economic growth.
You can think of The Fed’s monetary policy like a game of tug of war. At one end of the rope are contractionary, or restrictive policies. These are intended to slow the growth of the economy and help limit the rate of inflation. This is typically managed by raising short-term interest rates – higher interest rates means a higher cost of borrowing and less money in the economy, resulting in slower economic expansion.
At the other end of the rope are expansionary policies, also referred to as quantitative easing. These are intended to spur economic growth during periods of slowdown. This is typically managed by lowering interest rates – making it more economical and easier to borrow money typically leads to economic growth but can also result in rising inflation rates.
This game of tug of war is closely monitored by The Fed, transitioning between quantitative easing and restrictive policies with the goal of keeping the economy geared toward growth while simultaneously taking care to control inflation and stabilize prices.
How can monetary policy impact your investments?
While it’s impossible to say how any investment will perform at any given time, both restrictive and expansionary monetary policy have very real impacts on the general performance of various asset classes.
Policies focused on contraction
When The Fed is trying to control inflation and slow economic growth, it will typically move to raise interest rates. Asset classes will generally react as follows:
Bonds: Higher interest rates typically have a negative impact on bonds. Bonds typically pay a fixed yield based on the interest rate they’re issued at. If interest rates rise, bond rates rise as well. This means newer bonds will pay a higher fixed yield, driving down demand for previously issued, lower yield bonds. When demand drops, so does the price these can be sold for.
Equities: When interest rates rise, new fixed income investments with higher yields become more attractive to investors. This tends to drive down the risk appetite of investors, leading equities to underperform. In addition, when inflation rises, which is typically a prelude to restrictive monetary policy, speculation on the rising costs of goods and services leads to an increase in market volatility, which can impact returns on equities.
Cash: Rising interest rates can result in higher deposit rates, making cash deposits more attractive to investors than at times when rates are low. However, if the rate of inflation rises higher than interest rates, investors run the risk of not generating a positive real rate of return through cash holdings and could wind up losing money.
Policies focused on expansion
When The Fed is trying to stimulate growth, they tend to lower interest rates through quantitative easing. Asset classes will generally react as follows:
Bonds: Lower interest rates typically have a positive impact on bonds. If interest rates drop, existing bonds will likely pay a higher yield rate than newly issued bonds. This drives up demand for previously issued bonds, which tends to drive up the prices at which they can be sold.
Equities: During periods of expansionary policy, equities have a tendency to overperform. Depending on the extent of The Fed’s actions, it may be purchasing certain securities types while simultaneously lowering interest rates, making it easier for greater liquidity to enter the economy, resulting in boosted stock prices.
Cash: Low interest rates means cash tends to provide only minimal returns, so investors typically avoid cash and cash equivalent investments.
A note on asset allocation…
Regardless of the allocation of your portfolio, it’s important to understand its expected real rate of return. If your portfolio is conservative in nature and only generates a 2% rate of return at a time when inflation rises to 5%, you’re actually generating a negative 3% real rate of return. It’s been a long time since investors have had to plan for sustained inflation, so this may be a good time to review your portfolio.
Monetary policy, past and present
While it may not be a perfect analogue, the last time interest rates were on the rise alongside high inflation was a period of time extending from the early 70s to the early 80s. Inflation in the US surged to double digit numbers during this stretch.
Strangely enough, we find ourselves in a similar situation today. Inflation has climbed to roughly 6%, and there is speculation on whether or not this rise will be transitory.
Complicating matters, the global supply chain remains disrupted, making prices difficult to control, and The Fed has indicated that near term monetary policy will be restrictive in nature. With that being the case, investors would be wise to prepare their portfolios for a rising interest rate environment.
Steps you can take to help protect your financial well-being from rising interest rates
1. Diversify your portfolio. You’ve likely heard this a million times, but diversification within a portfolio is of paramount importance. With a diversified portfolio it becomes possible for one subset of asset classes to generate meaningful returns even as others struggle during volatile market conditions.
2. Own assets that can outpace inflation. Rising interest rates may make it difficult to generate meaningful returns from a portfolio heavy in fixed income holdings. Some examples of assets that may be able to counteract the low interest rate drag include equities or newly-issued, higher yielding bonds. It’s also important to understand how your assets could react to an inflationary environment.
3. Consider active portfolio management. Active portfolio management may offer an opportunity to better react to market volatility and fluctuations and potentially outperform passive strategies..
4. Take advantage of the current rate environment. While not directly related to your investment strategy, if you have a mortgage or other high interest loan, you may still have an opportunity to take advantage of lower rates or refinance before interest rates rise.
5. Stick to your long-term plans. Don’t make reactionary decisions to short-term market volatility. Stick to your investment strategy and play the long game as opposed to trying to time the ups and downs of the market.
Contact a PNC Investments Financial Advisor, today
While no one can say with certainty how the markets are going to react in the months ahead, it’s safe to assume The Federal Reserve will take action to take control over inflation.
Make sure you and your portfolio are prepared for any market volatility that may come.
To discuss your portfolio or personal investment strategy, stop by a local branch to speak with a PNC Investments Financial Advisor or call 855-PNC-INVEST, today.