Investors Languish in Interest Rate Limbo as They Await Next Fed Moves

In recent months, the stock market has had to contend with two major economic concerns—the drama over the lifting of the debt ceiling and speculation over future rate hikes by the Fed. Much to the relief of investors, the debt ceiling spectacle was solved, at least temporarily. But the market has continued to churn over concerns of how much further the Fed plans to go to win the battle over inflation.

Inflation News Improving, but the Fed is Still on the Warpath

The June inflation report indicating a marked cooling in price increases was a shot in the arm for a market desperately looking for a respite from further rate hikes. While the 3% year-over-year increase in June, the smallest since March 2021, marks a two-thirds reduction of the inflation rate that peaked at 9.1% in June of 2022, it remains above the Fed target of 2%, and consumers are still reeling from higher prices.

After a pause in June, most experts expect at least one more rate hike in July—taking the benchmark rate to 5.5%. Speculation now centers on whether it will be the last for a while. In its recent remarks, the Fed indicated that future rate hikes are still on the table due to continuing pricing pressures and a resilient labor market. However, no timetable or forecast of how high they could go was given.

One thing for sure is that short of the economy falling into a full-blown recession (which appears less likely this year), the Fed is not going to be cutting rates anytime soon. That will keep upward pressure on loan rates and bond yields well into 2024. How does that bode for investor portfolios going forward?

Implications of Current Rate Environment on Portfolio Decisions

While a considerable chunk of past, present, and future rate hikes has already been baked into the market, the prospect of rates remaining elevated indefinitely may keep a lid on stock prices and the market churning. Historically, stock market performance tends to be mixed during periods of rising or elevated rates. It can also vary among specific industries or sectors, which is why diversification is critical in any interest rate environment.

High-Quality Stocks Still Best Defense Against High Rate

It’s also an excellent reason to overweight your portfolios with stocks of companies with little or no debt. Higher rates can burden leveraged companies’ bottom line and increase the cost of producing or selling goods and services. High-quality, well-managed companies that aren’t capital intensive and don’t rely on debt to finance operations can perform well in a high-interest rate environment.

Bonds More Attractive

For several years, as interest rates plummeted, bonds have been the bane of investment portfolios, dragging down total returns with their low yields. Increasing rates over the last few years forced bond yields up while driving prices down, resulting in the worst bond market returns on record in 2022.

The silver lining in rising bond yields is that they have become more attractive for fixed-income investors or as a counterweight to stock market volatility. With the 30-year Treasury yield rising well over 4%, they are now exceeding the inflation rate of 3%. However, the consensus is that bond yields will continue to rise, at least into 2024.

Perhaps the biggest beneficiaries of higher rates are savings, CDs, and money market accounts. After languishing at near-zero rates for several years, rates with some accounts have soared to the 4% to 5% range, making them a more attractive haven for investors.

Preparing Clients for Rate Uncertainty

No one can predict what the Fed will do in its fight against persistent inflation, but a safe bet is that it will hike rates at least twice before yearend. Continued pricing pressure and a strong labor market could force more aggressive actions, but, at the very least, we aren’t likely to see rates coming down soon.

Any specific actions your clients take regarding their portfolios will depend on the assets they hold, their investment objectives, and risk tolerance. Diversifying among assets with low correlations with one another is still the best way to minimize portfolio volatility until inflation and fed rate policy normalize.