In the mid-December of 2023, the Federal Reserve, popularly referred to as the Fed, made no changes to short-term interest rates. This was a departure from their trend of the last two years, when rates were raised multiple times and were actually brought to their highest level in 22 years. As Kavan Choksi Professional Investor mentions, when the Fed changes rates, it can become more costly for consumers to borrow and more lucrative to save. This would essentially impact credit cards, mortgage rates, savings accounts and even investments.
Kavan Choksi Professional Investor briefly underlines how the Fed affects investments
As the Fed adjusts rates, it may end up creating turmoil in the markets. This happens largely because no one knows with high certainty which moves the Fed will make next, as well as how it might impact the asset classes they have invested in. Based on the direction in which the rates move, markets can respond in a distinctive manner, and investors may get spooked.
When rates are low, money would be relatively cheaper and help create a lot of liquidity in the economy. Both people and companies would be more willing to borrow more during this time. This also makes it more affordable for companies to invest in themselves. When it comes to individuals, it becomes for affordable for them to borrow money to invest in securities. Not only does this add more liquidity to the markets, but the more funds coming into the markets pushes up the prices of stocks and bonds as well. The opposite is true when interest rates go up. If the Fed increases interest rates then companies end up borrowing less and hence have less to invest in themselves. Lower corporate investments can result in weaker earnings. The bond yields rise in the meantime, with interest rates making them more competitive to the value of future corporate earnings. Stocks, which are riskier assets in comparison to bonds, tend to become less competitive when bond yields move higher.
As Kavan Choksi Professional Investor says, even alternative investments are not immune to the impacts of rate hikes. Cryptocurrency and other digital assets might be more speculative in nature, but even such investments do respond to changes in the Federal funds rate. At times, they even see a greater impact than more traditional assets. While investing in crypto can be a good way to diversify the investment portfolio, investors should try to limit their crypto exposure as well to avoid major dips in performance during times of uncertainty.
When it comes to investments, it is always better to play the long game, as trying to time the market and move in its accordance doesn’t always work out as expected. Spreading the investment risk across asset classes is the simplest yet most effective way to ride out short-term market bumpiness. Investors need to focus on diversification and try to revisit their asset mix from time to time to make sure that their portfolio still aligns with their current goals and risk tolerance.