The Federal Reserve's current rate-hike cycle, which began in March 2022, has pushed interest rates to levels not seen since 2007. That's welcome news to those looking to earn meaningful returns from bonds and cash but can hurt those needing to borrow for big-ticket items, like cars, college, or housing. However, where we are within a given rate-hike cycle can change that equation.
That's because rate-hike cycles, which the Fed uses to tame inflation and cool an overheating economy, ultimately lead to the point where an economy that's too strong threatens to become too weak. When that happens, the winners and losers can—and often do—switch places.
Here's a look at what normally happens in the early and later stages of rate-hike cycles, and who stands to win and lose within each phase.
Early in the cycle
Rate hikes make it more expensive to borrow, discouraging consumers from making large purchases and companies from hiring and investing. Over time, the effects of these trends can ease price pressures, but they can take a while to play out.
Unsurprisingly, bond buyers, lenders, and savers all benefit from higher rates in the early days. Bond yields, in particular, typically move higher even before the Fed raises rates, and bond investors can earn more without taking on additional default risk since the economy is still going strong.
Bond-fund investors, borrowers, and certain industries feel the pinch as soon as rates move upward:
- Bond funds, which regularly buy and sell their underlying holdings, can experience losses in the net asset value in the short term due to the inverse relationship between rates and bond prices. However, as they reinvest in new bonds paying higher rates, they often recover their losses.
- Borrowers who hold variable-rate debt, such as credit card balances and adjustable-rate mortgages, may see their payments increase almost immediately.
- Stocks in the consumer discretionary, industrials, and materials sectors tend to underperform in the year following the start of a new rate-hike cycle as investors anticipate that higher borrowing costs and inflation will sap profits for those companies more dependent on economic growth.
Later in the cycle
As higher rates begin to weigh on the economy, the threat of recession often looms large. Yet opportunities remain for savers and for stocks within certain industries as rates climb toward their peak.
- Savers continue to benefit as interest-bearing cash investments pay ever-higher yields. For example, some of today's CDs and money market and savings accounts are paying a meaningful 5% or more.1
What a difference a percentage point makes
Source: Charles Schwab.
The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Example assumes an initial investment of $100,000 and a consistent interest rate for all five years.
- Short-term bonds offer better yields, too, and even longer-term bonds become more attractive—10-year Treasuries, for example, are currently paying 3.99%,2 which, after more than a decade of rock-bottom yields, is a welcome change for income-focused investors looking to lock in higher monthly payouts.
- Stocks in industries that provide essential products and services—such as health care, household goods, and utilities—become more attractive when recession concerns mount, given that their revenues aren't closely correlated with economic growth.
Unfortunately, there are many individuals and entities who suffer during the late stages of a rate-hike cycle—particularly borrowers. For example, college undergraduates who take out federal loans for the 2023–2024 school year will face the highest interest rates in more than a decade. Today's soaring rates may also help explain why first-time homebuyers accounted for just 26% of U.S. home purchases last year—the lowest level in 41 years, according to the National Association of Realtors. On the business side, high-yield bond issuers are at greatest risk from higher rates, and stocks in high-growth industries, such as information technology, can also suffer as revenues slip while borrowing costs remain high.
Eyeing the end game
Ultimately, everybody wins if the Fed can successfully tame inflation while keeping the economy out of a recession and preventing a significant increase in the unemployment rate. But a recession may be unavoidable, in which case it can pay to play it safe with your investments. Focusing on stocks and bonds from financially sound companies and issuers, respectively—and diversifying your holdings across industries and countries—can help limit the impact on your portfolio should an economic decline come to pass.
1Bankrate.com, as of 07/11/2023.
2The Wall Street Journal, as of 07/11/2023.
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