You hear it all over the news: Inflation hit a record 8.6% year-over-year increase in May 2022. The Federal Reserve recently raised interest rates by an unprecedented 75 basis points to quell it. 

You might see the effects in your portfolio as well. Even if you diversified among global equities and investment-grade bonds, both have likely fallen in tandem. Year-to-date, a balanced 60/40 portfolio has drawn down nearly as much as a 100% stocks one. I know this because my account running a 3x leveraged version is heavily in the red. Thanks, J-Pow. 

How do interest rates affect our investment decisions?

To understand how interest rates affect investments, we first need to understand how they work as a monetary policy tool in today’s central-bank-led economy.

The Fed controls the money supply in part by changing its target for the Federal Funds Rate (FFR). By increasing or decreasing the FFR, the Fed can either stimulate or tighten the economy—and by extension, the stock market.

We saw this in March 2020, when J-Pow hit the turbo button on the Fed’s money printer and dropped its target to the basement (between 0% and 0.25%). The low cost of borrowing helped keep businesses alive through access to cheap capital and incentivized consumer spending, which stimulated the economy.

This spending unsurprisingly (and unfortunately) led to inflation—an increase in the price of a common basket of goods & services. To rein it in, the Fed is now raising rates. A 25-point raise in March and a 50-point rise in May barely dented inflation, hence the recent 75-basis-point hike. Only time will tell if this works.

(It’s worth noting that Former Chairman Paul Volcker jacked rates up to 20% in the 1980s when inflation was running above 11%. The result? A brutal recession in 1982 and 1983, but he did arguably save the economy in the long run … until now, that is). 

Relationship between interest rates and stock prices

In general, higher interest rates tend to negatively affect the earnings of companies, which can lead to an immediate effect on their stock price. A notable exception here is the financial sector, which may benefit from tailwinds thanks to the higher interest they can charge on loans, in turn improving their top lines (if all else stays equal, which isn’t always the case). 

When interest rates increase, short-term borrowing costs for companies shoot up. This has an outsized effect on growth stocks, which often rely on borrowed capital to invest in research and development, hiring, acquisitions, and in today’s day, subsidized goods and services (cough cough, Uber). A higher cost of borrowing leads to slower growth, which translates to lower expectations for share prices. 

Beyond growth stocks, increases in rates can curb household spending and disposable income as consumers lose access to cheap credit and stimulus. In turn, these consumers buy fewer discretionary goods and services (which in theory should quell inflation). The downside is that companies earn less, which can tank their earnings and share prices.

For this reason, we see that tech stocks are often hard-hit, along with consumer cyclical and industrial stocks that rely on either retail spending or capital expenditures, both of which require access to cheap capital. Consumer staple and healthcare stocks are often more durable because they’re selling necessities.

Relationship between interest rates and bond prices

When rates rise, so do bond yields. By how much? That depends on the bond’s modified duration.

A bond’s modified duration is its price change given a 1% change in interest rates, up or down. The higher the duration, the more sensitive a bond’s price is to interest rate changes. 

For example, a bond with a 20-year modified duration would lose approximately 20% in value if interest rates increased by 1%. 

Check out the returns for 7-10 year intermediate and 20+ year long-term Treasurys year-to-date. Both have experienced heavy losses, with the latter drawing down significantly more amid higher volatility. This has been devastating for investors who have traditionally relied on long-term Treasurys as a hedge against bear markets.

What’s even worse is that the negative correlation between Treasurys and stocks also conveniently disappears during a rising-rate environment, reducing their protective capabilities during a crash. And that’s kinda the whole point of bonds, right? To diversify your stock-heavy portfolio. Bummer.

What can I do to protect my investments in a high-interest rate environment?

Managed futures

Managed futures are hedge fund-like assets created to produce uncorrelated, positive returns in all market conditions. Common strategies include long/short, trend-following, and global macro for equities, bonds, currencies, and commodities. 

Managed futures—when implemented by a competent commodity trading advisor team—can produce strong returns when both stocks and bonds falter. They performed well this year as inflation and rates ran high. The downside is high expense ratios and poor performance during other times. Prior to 2021, many of these funds saw flat performance, like Lindsay Lohan’s career after Mean Girls.

Money-market instruments

Money-market instruments are ultra-short-term debt obligations with a AAA credit rating. This includes things like T-Bills and certificates of deposit (CDs). These instruments have virtually no default risk, making them risk-free assets.

They also have a low duration. These assets may have durations as low as 0.06, which means if rates increase by 1%, they will only lose around 0.06%. This can be a way to keep cash safe and substitute for a bond allocation. The downside is the very low yield, which will not keep up with inflation at all.

Series I Savings Bonds

I Bonds may be one of the best investments to own during a rising interest rate environment. These bonds offer a coupon rate that combines a fixed rate and an inflation-based rate. Remember that when inflation runs high, rates tend to follow. Right now, for I-Bonds issued and bought between May 2022 to October 2022, the annual interest rate is a whopping 9.62%.

I Bonds are also tax-efficient since they’re not subject to state income tax. They earn interest for up to 30 years unless you cash them first, which you can do after one year. If you cash your I Bonds before five years, you’ll lose the last three months of interest though. Also, you’re only allowed to buy $10,000 worth of electronic I Bonds every calendar year, which is a real bummer. 

Rising interest rates won’t last forever

Whatever course of action you take, remember that a rising interest rate environment will not be the status quo forever. Young investors with a long time horizon can simply stay the course.

Once rates rise sufficiently, there is a good chance the Fed will drop them again during a bad crash to stimulate the economy, just like they did in 2008 and 2020. In the meantime, sit back, relax, and try not to cry over your new gas and grocery budget.