For the past several decades, higher rates have not typically been linked to recessions. On the contrary, Federal Reserve chairs have often been criticized for keeping rates at excessively low levels for too long, leading to the dot-com bubble and the collapse of the subprime market, both of which triggered recessions in this century. Generally, higher rates are seen as beneficial as long as they’re associated with economic growth. Historically, higher rates have translated to higher fixed income yields, potentially providing investors with reliable future cash flows, a hedge against equity volatility, and improved return asymmetry.
Mortgage rates, credit card rates, auto loan rates, and variable-rate business loans are all expected to remain elevated, following the Federal Reserve’s indication at their most recent meeting that they do not intend to reduce interest rates until they have “greater confidence” that consumer-level price increases are slowing to their 2% target.
The central bank has maintained its key rate at a two-decade high of approximately 5.3% since last August. For awhile now, the idea of interest rates staying “higher for longer” has gained growing momentum. The scenario of prolonged higher interest rates can be advantageous for investors across various sectors, contrary to conventional expectations.
Enhanced Returns on Fixed-Income Securities
Over the long-term, higher interest rates can provide increased income for savers, especially retirees who rely on fixed income. When rates are high, banks typically offer higher interest rates on deposits, bond coupons increase, and entitlement payments like Social Security tend to rise. In an environment of higher interest rates, fixed-income securities become attractive investment options. Bonds and other fixed-income instruments offer higher yields as interest rates rise. Investors seeking stable returns find comfort in these securities, as they promise increased income streams compared to periods of lower interest rates. Moreover, the allure of higher yields can attract a broader pool of investors, further boosting demand for fixed-income assets.
Incentive for Savings and Investment
Higher rates can create new investment opportunities. For years, ultra-low rates boosted the stock prices of rapidly growing companies by making their future earnings appear more attractive in widely used pricing models. Additionally, relatively modest bond coupons supported the belief that there were no viable alternatives to those stocks. Extended periods of higher interest rates incentivize individuals and entities to save and invest. Higher interest rates amplify the returns on savings and investments, encouraging prudent financial management. Savers are encouraged to allocate funds to interest-bearing accounts and investment vehicles, stimulating capital accumulation and economic growth. Additionally, higher interest rates can encourage investment in long-term projects and ventures, as the cost of capital rises, promoting productive economic activities.
Balanced Risk-Return Profile
Investors often struggle with the trade-off between risk and return when making investment decisions. In a “higher for longer” interest rate environment, the risk-return profile tends to favor investors. The enhanced yields offered by fixed-income securities mitigate some of the risks associated with equity investments, providing a balanced portfolio strategy. Investors can diversify their holdings across asset classes, reducing downside risk while benefiting from the income generated by higher-yielding fixed-income assets.
Inflation Mitigation and Purchasing Power Preservation
Higher interest rates act as a defense against inflationary pressures, safeguarding investors’ purchasing power. Inflation gradually erodes the real value of money over time, diminishing the purchasing power of individuals and investors. However, higher interest rates can curb inflation by dampening consumer spending and investment, promoting price stability. Investors seek refuge in assets that offer returns exceeding the inflation rate, ensuring the preservation of their wealth and purchasing power over the long-term.
Prudent Financial Management
An extended period of higher interest rates fosters a culture of prudent financial management among investors and market participants. Heightened awareness of interest rate risk prompts individuals and entities to carefully assess their financial obligations and liabilities. Investors are incentivized to adopt disciplined investment strategies, emphasizing risk management and capital preservation. Consequently, the prevalence of sound financial practices contributes to the resilience and stability of financial markets.
While some investors may hope for a return to the low rates prevalent before the COVID-19 pandemic, it’s essential to recognize that the investing landscape has changed. Economic growth, inflation, and productivity were all subdued during that time. However, these conditions are likely to shift in the coming years due to factors such as business digitization, changes in the labor market, deglobalization, and evolving geopolitical dynamics. This suggests that interest rates may remain “higher for longer.” Contrary to popular belief, this isn’t necessarily negative and could present investment opportunities for patient and discerning investors.
Embracing the opportunities presented by prolonged high interest rates can pave the way for sustainable wealth accumulation and financial prosperity in the long-term. Reach out to an investor relations associate at AshtonBridge Capital today to learn more.