How to navigate rising interest rates

Why do interest rates change?

Interest rates change in response to various economic conditions and policies. The U.S. Federal Reserve, often referred to as the Fed, plays a key role in this process by setting the federal funds rate, which is the interest rate banks charge each other for overnight lending. The federal funds rate is set by a branch of the Fed called the Federal Open Market Committee (FOMC). The goal of raising rates is to reduce the supply of money in circulation, thus cooling off the economy. When Federal Reserve interest rates rise, it increases the cost of credit—helping to control inflation. As borrowing becomes more expensive, companies are less likely to take out loans and spend money, and individuals may postpone projects that involve financing.

How do rising interest rates affect the market?

When it comes to stocks, higher interest rates can have a negative impact. When rates go up, the cost of doing business increases, which could lead to lower revenue and earnings and, therefore, lower stock prices.

For bonds, when rates rise, new bonds are issued with higher interest rates, improving prospects for future income streams. However, the prices of existing bonds generally drop because their lower relative interest rates become less attractive.

Rising interest rates can have significant economic consequences, affecting everything from consumer spending to business investment. Higher rates make borrowing more expensive, which can slow down consumer and business spending, reducing economic growth. When inflation is high, these same forces can help stabilize the economy and keep prices in check by reducing the amount of money in circulation.

Understanding these dynamics is important for investors because interest rates can significantly affect the performance of various asset classes. For example:

• Bonds: Bond prices typically fall when interest rates rise, as new bonds issued at higher rates become more attractive to investors. However, the upside is that yields will be higher on the newly issued bonds.
• Stocks: Higher interest rates can weigh on stock prices, particularly for companies with high debt levels, as borrowing costs increase.
• Real estate: The real estate market can be negatively impacted as higher mortgage rates make home buying less affordable.
• Currencies: Higher interest rates can strengthen a country's currency, making it more attractive to foreign investors.
• Commodities: The impact on commodities can be mixed, but generally, higher rates can reduce demand for commodities as the cost of financing increases.

Interest rate changes can significantly influence portfolio performance. By staying informed, investors can make more strategic decisions, such as adjusting their asset allocations to mitigate potential risks and capitalize on opportunities. A diversified portfolio is still the best way to hedge against various risks in the long run.

Managing your portfolio during rising interest rates

You should weigh a range of factors when navigating the potential impacts of rising rates on your portfolio. Consider the current economic environment, the specific asset classes you're invested in, and your individual financial goals and risk tolerance. While rising rates can negatively affect stock and bond prices, they can also offer opportunities, such as higher yields on savings and fixed income investments.

Additionally, sectors like financials and utilities may perform differently, with banks potentially benefiting from wider interest rate spreads. You should also assess the broader economic indicators, such as inflation and GDP growth, to gauge the overall health of the economy. By carefully evaluating these factors, you can make informed decisions that balance potential risks and rewards, ensuring your investment strategies remain aligned with your long-term objectives.

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What NOT to do if interest rates rise

Rising interest rates are simply an indicator of the economy's current state, neither inherently good nor bad. It's natural to worry about worst-case scenarios, but it's important to focus on your long-term goals and not day-to-day market fluctuations. A well-diversified portfolio is your best ally in increasing your purchasing power over time. In a high-inflation environment, holding too much of your portfolio in cash and not having appropriate investments can erode your buying power, whereas a balanced mix of stocks and bonds can help you keep pace with the cost of living.

When markets fluctuate, resist the urge to make significant changes to your portfolio. Stay focused on your long-term plan and remember the gains you've likely experienced over the past decade. Transition periods can be challenging, but instead of dwelling on volatility, reflect on the overall growth of your portfolio. If your life circumstances haven't changed significantly, minor adjustments might be all you need to stay on track. Consider consulting Vanguard advice services to help you navigate these changes with confidence and avoid making hasty decisions that could undermine your financial future. Trust in your plan and the stability it provides.