What is An Interest Rate Rise, How to Protect Yourself & Benefit

An interest rate rise was once a normal occurrence in finance, with quantitative easing it is a novelty! An entire generation of Europeans have never seen a true interest rate rise cycle. With inflation risk having seemingly disappeared, the reflation policies being pursued by governments, means that investors should educate themselves to a new (future) reality. 

Takeaways

• What is an interest rate rise

• Why are interest rate rises back on the table

• How you can benefit and protect your portfolio

Why does an interest rate rise happen?

An interest rate rise happens because central banks are seeking to reduce inflation. Inflation occurs when an economy is growing and prices of goods are increasing. In effect raising interest rates allows an economy to 'cool off' and for prices to moderate.

When learning how to start investing, a new investor should realise that you invest to protect the purchasing power of your wealth. As prices rise, you ensure you can buy the same goods as normal without eroding your capital. Investing in a stock portfolio, ensures you are seeking capital preservation to protect from the dangers of inflation.

When is the last time this happened?

The last interest rate rise to occur was in autumn 2015, when it was felt that on balance the US economy could adsorb a rise. There was an element of it being a non-event, so much had it been telegraphed in advance by the NY Fed. Over the next 3 years, rates were raised to just over 2% in small gradual increases, each time the market being forewarned by various statements made by the then NY Federal Reserve chair Janet Yellen. Many thought an increase in interest rates sensible to prepare for the next financial crisis.

How was this received by the stock market?

Western markets saw this as a non-event because of the communication policy of the NY Fed. This policy was to ensure that no panic would happen. This was after a lesson from the 2013 taper tantrum, when US treasuries sold off after comments from Ben Bernanke, the then US NY Fed chair.

Indeed back in 2013, the most volatile stocks were ones which involved a foreign portfolio investment, as they sold off. This was due to the perceived negative effect of an interest rate rise on Emerging and Frontier markets.

What happens when interest rates rise?

An increase in interest rates today, especially one caused by increased inflation expectations, would likely cause a sell off in some of the fashionable growth stocks, such as Tesla stock. This would mean momentum trading becoming unfashionable. Hedge fund managers would likely position themselves in value stocks ahead of this.

Value stocks are seen as having better 'value'. This is due to their profits being sustained by selling products which are needed for every day life. As a result these tend to have lower margins and their share prices do not charge upwards. With this in mind, your buy and hold strategy may need tinkering, and you should be ready to perform a sector rotation.

You may also find some fashionable assets lose value. If saving accounts were paying a decent amount of interest, would clueless retail investors really get involved in cryptocurrency trading?

How to profit

The obvious place would be to buy financial stocks such as banks. As interest rates rise, they can charge more on the loans they lend. This would be a way to profit and protect yourself from inflation and the associated increased interest rates.

You should be aware that this could be a poison pill. Increased interest rates, may mean increased profits, but it could also mean increased foreclosures. Many homeowners are unprepared to the increased cost of their monthly mortgage payments.

Inflation protected bonds are an option. Examples include Treasury Inflation-Protected Treasury (TIPS) in the US or an Index-Linked Bond in the UK. In both cases, the value of the coupon and the final amount on maturity is uplifted by inflation. For investors seeking to preserve their capital this is attractive, but for those contrarian investors it may be a 'trade' to get into early.

Conclusion

Apart from pass-through inflation, inflation has yet to materialise. This and the seemingly constant need for low interest rates to protect growth, means an interest rate rise is unlikely soon.

Indeed Covid lock downs have caused devastation to certain industries and many economies. This suggests that low rates are here to stay. As an investor you should be ready for all manner of risks. This may mean preparing now for a risk which may come alive tomorrow!