The sudden rise in interest rates over the past month has spooked some investors. Fears of runaway inflation, the Fed losing control, and concerns over highly-valued sectors have resulted in market swings. While shocks to interest rates can rattle markets, history shows that these events are actually positive. How can patient investors keep these concerns in perspective?
Rising rates are more often a positive sign for markets
It’s important to understand what influences interest rates. In the short run, the buying and selling of bonds can mechanically push rates lower or higher. When investors are concerned about the world, as was the case early in the COVID-19 pandemic, they often buy Treasuries and similar securities as a “flight to safety.” This increases the prices of these bonds and lowers their yields. The opposite is true when investors sell bonds which pushes interest rates higher.
Over time, through this buying and selling, interest rates settle in at levels that correspond to expectations on economic growth and inflation. Thus, interest rates can be both reflections and forecasts of economic trends. Rising rates signal the possibility of stronger growth ahead which is often positive for riskier assets like stocks. So, although spikes in interest rates can be disruptive to the stock market for a short time, rising rates are more often a positive sign for markets.
The chart below shows the yield curve (the level of interest rates across maturities) compared to one quarter and one year ago
Rising interest rates are consistent with an improving economy
As a result, rising interest rates are normal and are not necessarily something to be feared. They are consistent with the positive economic data over the past several weeks including an improving job market, recovering industrial production, and the on-going rollout of vaccines.
However, this does mean that investors should keep a close eye on their asset allocations. Many areas of fixed income have declined this year as a result of higher interest rates (remember, when interest rates go up bond prices go down) and shrinking credit spreads, with the overall U.S. Aggregate Bond Index down 2%. Fortunately, fixed income will likely still provide a counterbalance to portfolios in periods of uncertainty, even if yields are lower.
The bottom line? Stay focused on the long term
Finally, if the past two business cycles have taught us anything, it’s that Fed rate hikes are nothing to fear if they occur alongside an improving economy. In fact, the fear is often worse than the ordeal itself.
For instance, the 2013 short-term spike in rates known as the “taper tantrum” was a consequence of investors over-reacting to then-Fed president Ben Bernanke’s comments. Although rates spiked for a few months, they eventually settled back down. The stock market continued to rally for years thereafter. Although it’s understandable that the market often scrutinizes Fed decisions, it’s often more important to focus on the underlying economic trends instead.
For long-term investors, all of this reinforces the need to stay focused on your long-term financial goals rather than daily market movements. Check out MoneyLion fully managed portfolios. They’re built to withstand the markets whatever the weather — with no management fees or minimums.