How To Invest If The Fed Keeps Raising Interest Rates

The central theses

  • The Fed raised interest rates by 0.75 percentage points at its September meeting
  • Further rate hikes are expected, with the long-term rate expected to reach 4.4% in 2023
  • It’s bad news for businesses and the economy in general as markets plummet after the announcement.
  • Investors need to think outside the box to make profits in such an environment, and pair trades are an option to consider.

The Fed was widely expected to hike rates by 0.75 percentage point at its September meeting, marking the third straight hike. And that’s exactly what happened.

The hike brings rates to a range of 3-3.25%, the highest level since the massive wave of cuts that followed the global financial crisis in 2008.

In addition to releasing its latest target interest rate, the Fed also announced its revised economic forecasts for the remainder of this year and through 2023.

It paints a pessimistic picture that is unlikely to calm the nerves of companies and investors, but thankfully there are always avenues to explore and unique angles to turn a profit.

Let’s go through the Fed’s announcement and see how investors can potentially generate returns in what is proving to be a difficult environment.

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Fed announcement overview

In addition to raising interest rates by 0.75 percentage points, Fed economists also provided a number of new forecasts for the economy.

Economic growth is expected to be a sluggish 0.2% in 2022, before picking up slightly to 1.2% in 2023. Unemployment is also expected to increase. It’s currently at 3.7%, which is low, but it’s expected to slowly increase to 3.8% by the end of the year and then to 4.4% by 2023.

Perhaps even more surprisingly, the Fed is forecasting inflation to fall significantly over the next 12 months. As of this writing, the overall rate is expected to drop to between 2.6% and 3.5% in 2023.

That decline likely won’t be without pain for businesses and consumers, as the federal funds rate is expected to rise to 4.4% by the end of 2022, and rise again to an estimated 4.6% in 2024.

What interest rate hikes mean for the housing market

The Fed’s main goal in raising interest rates is to reduce consumer spending. If the key interest rate rises, it becomes more expensive for the banks to borrow. This cost increase is passed on to their customers in the form of an increase in interest rates on borrowed funds.

Whether it’s personal loans, car loans, credit cards, and of course mortgages, it makes them all more expensive.

Rising debt costs mean households have less money to spend on other things. Less money means less demand for goods and services, which increases supply and lowers prices. Or at least prevents them from rising so quickly.

It’s not good for business, but it takes the heat out of inflation.

Mortgages have the biggest impact on household budgets because they’re generally one of, if not the, biggest expense they have.

The average interest rate on a 30-year mortgage has recently risen to 6.25%. This is the highest level since the days of the 2008 global financial crisis.

That’s a 35 basis point gain ahead of the Fed meeting, with expectations of a 0.75 percentage point rate hike already priced in. This means that we may not see another rise from here, at least until the next Fed meeting closer.

As for the broader housing market, it is not expected to avoid the damage that is likely to be felt by the rest of the economy. Fed Chair Jerome Powell stated that the housing sector is likely to undergo a correction after experiencing a period of “hot” prices.

How will savers be affected?

On the other hand, a rate hike is good news for savers. The often forgotten group when it comes to base rate changes have the opposite problem of borrowers.

Low interest rates mean fewer incentives to save, and meager interest rates are forcing people to look for other ways to earn a return. If the Fed is trying to stimulate the economy, that’s a good thing.

Low interest rates on savings can mean more money is flowing into assets like bonds and stocks, which can increase market activity and drive up prices. It can also lead to increased spending as there is less incentive to put money away.

This has been the situation since 2008, with savers now accustomed to receiving next to nothing in their savings accounts and CDs. With rising interest rates, this could finally change.

Increased interest rates mean banks can offer high interest rates on their cash accounts. As might be expected, this has the opposite effect of falling interest rates. Savers have more incentive to keep their money in the bank when they feel they are making a decent return.

With bank rates often below 1%, it was a no-brainer for savers to invest that money in the stock market instead. If interest rates rise to 4% or even more, this question becomes much less clear-cut.

Of course, an interest rate of 4% in real terms is still negative if inflation remains at its current pace, but we could still see rising savings and CD rates changing consumer behavior.

This is more bad news for the business as it pulls more money out of the system again, which means less cash spending.

All in the hope of bringing down inflation. Fed Chair Jerome Powell has made it clear that this is their top priority, even if it means damaging the economy in the short term.

How did the stock market react to the rate hike?

Although widely expected and reportedly priced in, the S&P 500 fell 1.71% on Wednesday. Concerns about the outlook for the US economy are growing, with Powell’s announcement showing that a recession is becoming more likely.

The Nasdaq Composite fared even worse, falling 1.79% and the Dow down 1.70% on Wednesday.

It is likely that the decline in markets was not due to September’s rate hike but rather to anticipation and clarity of further hikes. There are two more Federal Open Market Committee (FOMC) meetings before the end of the year and it would be a surprise if both didn’t announce rate hikes.

What options do investors have now?

With interest rates on cash accounts rising, it could be tempting to move some funds from the markets to this safe haven.

There are a couple of big issues with that. Number one is that most investors are likely to be sitting on fairly large losses right now, and selling and cashing will include them.

The best CD rates on the market are still just over 3%, and these come with serious embargo periods of up to five years. Since inflation is still very high, you would have a negative real return.

That’s not a great strategy.

So we’re probably headed for some economic turmoil, the stock market is already looking choppy and the money is still not coming to the party. You could try picking stocks, but it’s fraught with danger and could easily end up worse than just leaving your money in the bank.

One answer is to use pair trades to invest in relative valuations. We’ve created a series of investment kits that use pair trades to do just that.

A great example is our Large Cap Kit. In volatile markets, large companies tend to outperform small and medium-sized companies. They typically have more stable earnings, more cash reserves to fall back on, and are less reliant on acquiring new customers to turn a profit.

That’s not to say they can’t fall in value, but they often fall less than smaller companies, which can find it very difficult to navigate economic downturns.

The Large Cap Kit seeks to profit from this difference by taking a long position in the top 1,000 companies and a short position in the next 2,000. This means investors can benefit even if the market goes sideways or even down, as long as large companies fare better than small or mid-sized ones.

It’s the type of trading typically reserved for baller hedge fund clients, but we’ve made it available to everyone.

Download Q.ai today for access to AI-supported investment strategies. If you deposit $100, we’ll add another $100 to your account.

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