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Interest Rates Are Rising – What Does This Mean for Your Portfolio?

Hot air balloons rising above mountain scene

If you’re thinking about buying or refinancing a house, you already know that mortgage rates are higher. But not all the news is negative – savers may start finding higher rates on CDs and money market accounts. While interest rates have been rising, with the benchmark 10-year Treasury rate above 3% for the first time since 2014, we think this reflects expectations for better U.S. economic growth in 2018 as well as somewhat higher inflation.

Since rates remain relatively low and have been rising slowly, they shouldn’t slam the brakes on economic or earnings growth. In the past, rising rates due to an improving economy have been good news for investors. But increasing interest rates have contributed to more volatile markets, and you may need to reposition your portfolio to take advantage of changes in the investment landscape.

More Fed rate hikes expected

When interest rates are increasing mainly in response to improving economic growth, as we think they are today, stocks and bonds have generally done well.* And as long as inflation doesn’t rise sharply, we think the Federal Reserve will continue to try to sustain economic growth, not snuff it out. As the chart shows, the past three recessions haven’t started while interest rates were rising.

Rising Interest Rates chart

Source: Factset, 3/31/2018.

If the economy continues to grow moderately, wages keep rising and inflation stays near its 2% target, we expect the Fed to continue quarterly increases in short-term interest rates. In addition, the Fed is steadily reducing its bond purchases to shrink its balance sheet. These actions mean monetary policy will slowly reduce the amount of stimulus for the economy, but we don’t think conditions have become tight enough to start to slow activity. In contrast, monetary conditions in the rest of the developed world remain extremely accommodative as many foreign central banks continue to try to boost growth. And fiscal policy is likely to accelerate U.S. economic growth this year due to the impacts of the tax cuts and the rising federal budget deficits.

Adjusting your portfolio to higher interest rates

The Fed has steadily hiked short-term interest rates, but as the chart shows, long-term interest rates haven’t risen as much. Higher rates and the smaller difference between long- and short-term rates have made cash and short-term fixed-income investments more attractive. And when interest rates rise, long-term bond prices generally decline more. In addition, higher interest rates compete more powerfully with high-yield stocks and may reduce the value of high-growth stocks, making both less attractive.

To reduce the impact of rising rates on your portfolio, we recommend:

  • Keeping a little more in cash and short-term fixed-income investments
  • Having no more than 15% of your bond portfolio in long-term bonds
  • Reducing high-yielding equity sectors of telecom, utilities and real estate that have been more sensitive to rising rates

More volatility ahead

When interest rates start to rise from low levels, stocks can continue to benefit from better economic and earnings growth. But short-term volatility usually increases, too, as investors worry about changing conditions and sentiment shifts quickly from optimism to pessimism.

Don’t let rising rates keep you from owning investment-grade bonds – they still help reduce swings in the value of your portfolio when stocks drop because they tend to decline less or even rise. And higher rates make them more attractive for current income, too. Stay prepared with a variety of asset classes that combine into the right mix of stocks and bonds based on your risk tolerance and long-term financial goals.

Important information:

*Source: Morningstar Direct. Rising rate environments defined as periods when the Federal Funds short-term interest rate was rising and in the range of 1%-3%. The average annual return of the S&P 500 Total Return Index was 18.7% during these periods. The average annual return for the IA SBBI Long-term Corporate Bond Index was 3.5% during these periods. Investment Indexes are unmanaged and are unavailable for direct investment. Past performance does not guarantee future results.

Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates, and investors can lose some or all of their principal. Diversification does not guarantee a profit or protect against loss in declining markets.

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