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Back in November 2021 when we asked our Minority Mindset readers, “Are you worried about inflation?”, an overwhelming 81 percent of you replied, “Yes, it’s out of control”. And as it turns out, you had every right to be worried. Throughout 2021, the CPI (consumer price index) rose at an unprecedented rate and inflation is now the highest that's been in almost 40 years at 7.9 percent.
The U.S. Federal Reserve, the agency tasked with controlling inflation, intends to fight back by using one of its key instruments: interest rates. Starting in March, they lifted the federal funds rate by 0.25 percent and made it clear that they plan to do this at least six more times this year.
Typically, when this is done, the cost of borrowing money becomes more expensive and it results in the prices of goods and services changing less frequently. While this is a desirable result for the overall economy, it can create situations where the stock market dips or (in more extreme cases) the country heads into a recession. Investors who are nervous about these rate hikes may want to introduce a few important assets into their portfolios.
There are many great ways to invest with rising interest rates. The key is knowing how these changes will affect some asset classes over others, and then reallocating some of your portfolios to serve as a hedge without abandoning your long-term investment plan.
In this post, we'll explore each of these asset classes and talk about a few unique investments that should be able to weather the storm. We'll also explain why they may be better positioned to handle the Fed's rate hikes so that you can decide if you'd like to integrate them into your overall investment strategy.
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Stocks That Move With Rising Interest Rates
Whenever the Federal Reserve begins to raise interest rates, one of the first things to happen is turmoil in the stock market. This is due to investors panicking that companies won’t hit their earnings targets.
Why would that be? Businesses are constantly borrowing money for the things they need like expansions, acquisitions, hiring, producing more inventory, etc. However, when the cost of borrowing money becomes greater, they won’t be able to do these things as cheaply as they did before, and the net result is generally some decrease in earnings or profits.
Fortunately, these losses are usually only temporary. As supply and demand begin to stabilize over time, companies adjust their operations and projections to accommodate these new levels. However, until that happens, there can be a lot of share price fluctuation and the market overall may dip for an extended amount of time.
However, not all stocks are in jeopardy when this occurs. Here are a few categories worth looking into.
First things first, when you think about someone who would profit from rising interest rates, it's going to be financial companies. Lenders adjust their interest rates based on something called the prime rate. This is an internal rate that’s used to set all other rates for things like mortgages, auto loans, credit cards, etc.
As you can guess, when the central lending rate increases, the prime rate gets adjusted too. However, the offset is not necessarily linear. The banks may add some small margin knowing that they may not get as many borrowers, and this helps them to maintain their profits to a desirable level.
Remember that the Federal Reserve is raising interest rates in response to high inflation. Generally, when there’s inflation, you’d expect people to make less discretionary purchases because their money is not going to have the same purchasing power that it once did.
However, non-discretionary purchases are still a must. The public still needs things like:
- Household goods and cleaners
- Internet / phone service
The companies that provide these types of consumer staples will do well. As a matter of fact, some of them may even do a little better than they did previously now that it will be acceptable to charge a higher price thanks to inflation.
Companies that provide these necessities are traditionally known as “value” companies. A value company focuses on profits as opposed to growth. When its stock price is relatively low, investors will typically buy shares of the company believing that they are getting it for less than it's really worth (in other words, at a “value”).
Most value companies are ones that are easily recognizable by name. For a complete list of large-cap value stocks, click here.
Another group of stocks that usually gets a small boost after the federal fund rates increase are dividend-paying stocks.
The reason for this is simple:
- Despite the market as a whole losing value on the news of the rate hikes, companies that pay dividends will tend to keep their distributions the same.
- Since dividend yield is calculated by taking distributions divided by share price, the dividend yield will begin to appear greater than it once did.
- Investors who are already worried about the turbulent market will flock to the safety of companies that pay dividends. Now that the dividend yields have just increased, they will appear even more attractive to investors as a way to hedge potential losses.
Of course, it will be good due diligence to make sure the company didn’t temporarily raise their dividend payment just to attract new investors. The best dividend-paying stocks are the ones that can consistently pay distributions while maintaining a reasonable share price. Coincidently, a lot of these companies will also be the value companies we mentioned earlier.
Anyone interested in researching and buying individual stocks can do so using Robinhood. Not only are the trades commission-free, but you don’t have to maintain an account minimum and you can also buy fractional shares if needed.
Bonds And The Federal Interest Rate
When it comes to treasury bonds, it’s easy to confuse the role of the Federal Reserve and the U.S. Treasury. Even though the two are completely separate entities, they each have a part in how bonds are handled.
- Treasury bonds (or T-bonds) are issued by the Treasury Department. They sell these bonds as well as collect tax revenue to raise money for the country.
- The Federal Reserve on the other hand is tasked with ensuring that lenders and borrowers have access to the capital they need. This keeps the power away from private banks (who primarily controlled the entire financial system back in the early 1900s) and ensures that the economy remains stable.
Why is this important? Because the two agencies will influence one another when it comes to the rates that are assigned to bonds.
When the Fed increases rates, the Treasury sells bonds with higher rates and vice versa. However, depending on the bond’s term (i.e., number of years until it matures), its perceived value in the market could be less than face value. This is why it will be important to differentiate between long- and short-term bonds.
Short Term T-Bonds
People often think of long-term treasury bonds as some of the safest investments a person can make. However, the issue with long-term bonds is that an investor can get locked into a relatively low rate.
For example, let’s say I bought a long-term bond with a 3.0 percent yield last year. The Fed increases interest rates, and short-term bonds are now paying a higher yield. As you might guess, no one would want my lower-valued long-term bond unless I was willing to sell it at a discount.
For this reason, it may be better to invest in short-term bonds to capture the more attractive rates. They will be the first to mature and allow investors to lock into the latest higher rate.
TIPS, or Treasury Inflation-Protected Securities, are another type of bond that can be beneficial during times of high inflation. As the name suggests, these are government bonds that get adjusted for inflation (more specifically, by the latest change in the Consumer Price Index).
TIPS can help ensure that the investor’s principal never loses purchasing power since the value naturally rises with the cost of all goods. However, remember that the goal of the Fed raising interest rates is that they are fighting inflation and hope to reduce it.
TIPS investors shouldn’t have to worry because this doesn’t mean the inflation rate will go down to zero or even negative. The more likely scenario is that inflation will taper off from its peak and gradually dwindle back to a reasonable level (hopefully 2 percent or so). However, this could take several months or even years. Therefore, investing in TIPS may be a good temporary solution until you begin to see evidence of inflation going down.
Investors who want to put their money into either type of bond can consider:
- Vanguard Short‑Term Treasury ETF
- SPDR Portfolio TIPS ETF
You can easily buy ETFs through a finance app like M1 Finance.
Real Estate and Changes by the Federal Reserve
Real estate is an interesting asset class when the economy is in a state of flux. Generally speaking, it can provide some form of a hedge against falling stock prices. However, the market can also be just as fickle depending on how private and commercial consumers react to the events that unfold.
Despite these characteristics, here are a few areas where investors may prosper from rising interest rates.
Although most people think of REITs as being invested in large commercial real estate, they can also specialize in debt – particularly with loans to private and commercial borrowers. These types of securities are called Mortgage REITs (or mREITs).
Similar to the rationale behind why financial companies do well from Fed rate hikes, mortgage-backed REITs may see some growth. Recall that as the Federal rate is increased, the rates of mortgages will also increase. This means anyone who issues mortgages should potentially benefit.
Again, thinking about the industries that consumers will not be able to forgo, healthcare is one major area that is unfortunately non-negotiable. Doctors and hospitals can effectively charge whatever they want (or whatever is dictated by the insurance companies) for the services and supplies that people need to maintain their health.
As a result, it's unlikely that any healthcare facilities would default on their lease payments. It's also possible that some may look to expand their footprint to larger and more modern locations. Either way, these are opportunities for REITs that specialize in healthcare-related projects and tenants.
Crowd Funded Real Estate
Even during periods of high inflation or Federal Reserve rate hikes, real estate developments continue to move forward. Sometimes they will start from the ground on up or by renovation. Other times they will be through strategic acquisition with existing tenants.
Anyone who wants to passively capitalize on real estate without the hassle of owning physical property can always invest in crowdfunded real estate. These are crowdfunding platforms that vet various real estate development projects and then use the money invested by its members to serve as capital.
On the surface, crowdfunded real estate has a lot of similar characteristics as REITs. In fact, many of these platforms offer non-traded REITs that can only be bought privately through them.
However, these platforms have some unique advantages beyond what traditional publicly-traded REITs can offer, such as better returns and connections to higher-end investors with exclusive projects and sector-specific real estate.
If you’d like to invest in crowdfunded real estate, check out platforms like Fundrise and RealtyMogul. Both accept accredited as well as nonaccredited investors, and Fundrise allows you to get started with as little as $10.
Cryptocurrency as a Hedge Against Interest Rates
To some degree, cryptocurrency is such a relatively new asset class, and so it’s difficult to fully predict how it will be affected by influences like inflation, Federal Reserve rate increases, and the potential for stock market turbulence.
Bitcoin, the oldest and most well-known cryptocurrency, has more or less moved in tandem with the stock market. Therefore, it's reasonable to expect that if stocks decline or the economy goes into a recession, then Bitcoin may not be the most desirable asset (even though this may not be true since the price of Bitcoin has remained fairly level around $40,000 despite the recent actions by the Fed and the war in Ukraine).
However, investors need to remember that the cryptocurrency industry is much bigger than just Bitcoin. This is why they may also want to consider the following.
Altcoins or “alternative coins” are technically any crypto asset that’s not Bitcoin. There are now more than 8,000 different cryptos available on the market, so there’s plenty of space for growth opportunity regardless of what the Federal Reserve decides to do.
For example, last year a relatively unknown token called Solana started the year at $1.84 and peaked at $169.98. That’s an increase of over 9,000%!
While growth spurts like this are rare, it just goes to show you how bullish many investors are about the industry. For instance, Ethereum (ETH), the second-largest crypto on the market, has been predicted to increase by as much as 4 times its current value by the end of 2022. Other popular coins such as Cardano (ADA), Litecoin (LTC), Polkadot (DOT) are also expected to come close to doubling in value as they pick up more market cap.
Some investors may understandably be put off by the wild fluctuations of Bitcoin and other altcoins. However, not all forms of crypto are erratic.
Stablecoins are a type of crypto that is tied to the value of a fiat currency (such as the U.S. dollar). By design, they’re meant to provide a “stable” means of converting fiat currency into digital currency and back again.
Here are a few of the most popular types of stablecoins:
- Tether (USDT)
- Gemini (GUSD)
- USD Coin (USDC)
While that might not sound like much of an investment opportunity, investors may be surprised to learn that many crypto platforms are offering crypto holders sizable amounts of interest for their stablecoins. They can do this because they take that crypto and then loan it out at a higher rate of interest than what they’re paying the owner.
How much interest? Some exchanges like Gemini are offering as much as 8 percent depending on which type of stablecoin you have and how much is in your account.
It should be noted that even though this arrangement may feel like a savings account, it's not. Please consider it an investment since there’s no FDIC insurance and some volatility risk is still present.
Finally, another crypto investing strategy that’s generating income for people is crypto staking. Staking is when a crypto validator puts up a portion of their holdings to take part in the proof-of-stake (POS) process of validating transactions. Their reward for doing this is newly mined coins, and a percentage of the earnings is shared with all who helped finance the stake.
From the investor’s perspective, this is a lot like locking up your money into a CD with a bank. You won’t have access to your capital, but at the end of the term, you’ll be paid a set amount of interest.
Crypto staking with platforms such as Coinbase are currently paying decent interest rates between 4 and 5 percent. The only downside is that there is the potential that your crypto value may fluctuate and lose value while it’s locked up. Therefore, before you commit, you’ll want to double-check the holding period and make sure it’s a length of time that you’re comfortable with.
Investing with Rising Interest Rates
When inflation expands to an unacceptable level, it’s the job of the Federal Reserve to control it. And one of the major tools that is used to accomplish this is by raising the federal funds rate.
Though raising interest rates usually slows down the economy and helps prices to stabilize, it can have undesirable consequences such as dips in the stock market or even temporary recessions. People who wish to protect their capital will want to look for investments that have the opportunity to proposer when the interest rates are on the rise.
The first place to look are stocks. Financial companies that act as lenders will benefit directly from higher interest rates. Value companies and dividend-paying stocks are also well positioned during times like this because they usually are rooted in products and services that people need no matter what happens to the economy.
Though the classic line of thinking is to invest in bonds when the markets are heading for bad weather, long-term bonds will suffer the most from rate hikes. Investors should consider short-term bonds because the turnover will be faster and adjust to the new, higher rates quicker. TIPS may also be a good temporary place to hold money since they're naturally indexed to grow with inflation.
Real estate is a good way to diversify outside of stocks and bonds, and provide some buffer while interest rates increase. REITs that specialize in mortgages or healthcare services will typically do the best during these times. There can also be a lot of opportunity for growth with crowdfunded real estate.
Finally, in 2022, it’s hard to ignore the potential of cryptocurrency as an alternative investment. Many of the major altcoins may see incredible growth despite however many times the Federal Reserve raises rates. Crypto interest and staking can also be clever ways to earn steady returns too.
The bottom line is that when inflation is too high and the Federal Reserve does what they have to stabilize it, the months ahead may be somewhat unpredictable. However, that doesn't mean we can't use logic to seize good investment opportunities. Consider how each of these strategies can work to your benefit and choose the ones you feel comfortable working into your investment plan.