Why You Should Hate Higher Interest Rates

If you invest in stocks, you want interest rates to be low. All things equal, increases in interest rates are a negative for the stock market.

One reason is that when interest rates rises, typically so do bond yields. For example, if an investor can get a 5% (annual) yield on a Treasury note—considered to be “riskless” because it’s backed by the U.S. government—they would need stocks to have a higher expected return in order to take on the higher risk (more volatility) of owning a stock. As a result, some money that would have been used to invest in stocks is used to buy bonds instead.

Of course, you could argue whether government debt is truly riskless, but over the short run, if you hold Treasury debt to maturity, you are very likely going to get the full principal back.

Another reason is that when interest rates rise, it decreases the value of stocks by reducing the present value of companies’ future earnings and cash flow.

A Drop in Present Value

Two common models used to value stocks are the Gordon Growth Model (GGM) and the Discounted Cash Flow (DCF) model.

GGM calculates what the stock price should be based on projections of future dividend and dividend growth. Meanwhile, DCF uses projected future cash flows.

Both models calculate the present value by discounting the future dividend payments or cash flow. This done by dividing the future cash flow streams each year by a certain discount rate.

It’s too complicated to go into how the discount rate is determined in this article. Suffice it to say, when interest rates go up, the discount rate does as well. This increases the denominator in the calculation and reduces the present value. For example, holding all else equal, a one percentage increase in the discount rate used in the calculate can decrease the estimated value of the stock by 10% or more.

Fixed Income Not Spared

Higher interest rates don’t hurt only stock investors. If you own fixed income instruments such as bonds, when interest rates rise, the value of your bonds will fall. This inverse relationship is even surer than that between interest rates and stocks. If you have to liquidate the bonds, you could end up eating a big loss. This is what happened to the regional banks that failed. They were forced to sell debt assets at big losses.

However, if you are able to hold to maturity, you will still end up getting the full principal back plus coupon payments (if any). Also, if you didn’t have any bonds to begin with, higher interest rates will allow you to buy bonds at a lower price than before.

Tripling Mortgage Rates

Even if you aren’t involved in the stock or bond markets, higher interest rates can still hurt you in your everyday life. The most direct and clearest impact is when you have to take out a loan, such as a mortgage.

According to data from the St. Louis Federal Reserve, between its trough in early 2021 and its recent peak in late October, the average nationwide 30-year fixed mortgage rate effectively tripled. While it has come down slightly in recent weeks, the rate is still above 7%.

If you were to take out a 30-year $500,000 mortgage at a 3% rate, your monthly mortgage payment (not counting other charges such as property tax) would be $2,108. But at a 7% rate, the monthly payment rises to $3,327, a 58% increase. Over the course of one year, that’s a difference of more than $14,600. For many Americans, that’s the difference between being able to afford a house or not.

Even if you don’t invest and simply put your cash in a savings account, while you will earn a higher nominal interest rate from your bank, when adjusted for inflation, your real return could very well have fallen.

PS: As you position your portfolio for next year, turn to utilities stocks. The utilities sector has gotten clobbered lately by rising interest rates, but it’s poised to rebound when the Fed pivots in 2024. That means value plays are ready for the picking.

However, you need to pick the right ones. For our list of the highest-quality utilities stocks, click here now.

John Persinos is the editorial director of Investing Daily.

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