This post originally appeared on Tim Thomas / Timothy Thomas Limited, we are republishing here with permission.
After many years of historically low-interest rates following the 2008 financial crisis, it seems that surging inflation will force the Federal Reserve to increase its rates.
Rate rises have implications for businesses and households alike, so here are 5 things to expect from the increases and the knock-on effects.
It’s still unknown how the conflict in Ukraine will impact the Fed’s plans. Although the Ukraine crisis may slow the pace of the increases, there’s no reason to doubt the rises will still occur from March 2022 onwards.
Most people now have the question: What now, and what will the knock-on effects be?
1) US Dollar Strengthening
On one level, an increase in inflation should mean that a currency loses its value. After all, if you can buy your weekly groceries for $100 one month, but inflation means that the same grocery shop costs $110 a few weeks later, the purchasing power of a single dollar has reduced.
What happens on a macroeconomic scale?
Usually, inflation harms a currency relative to the currencies of other nations. Yet this assumes that other currencies haven’t also experienced inflation — and rising prices have practically been a worldwide phenomenon since Covid-19.
A currency’s value relative to others also links to interest rates. When the Fed increases interest rates to control inflation, it may increase the demand for foreign investment since returns become higher.
Yet many other aspects influence investment in a country, such as its economic and political stability.
What we’ve seen so far is the product of various factors — inflation and interest rates increases are playing a role in the value of the US dollar, but so are international affairs.
Thanks to the fluctuating value of the Russian rouble over the last few weeks, the US dollar has also been volatile. On Thursday, Feb. 24, it reached its highest value since June 30 2020, and enjoyed the most significant percentage increase since November 2021.
Although there have been some recent decreases, the US dollar will likely strengthen over the coming year.
2) Oil and Other Energy Prices Rising
Oil is notorious for being one of the most volatile markets there is, and it’s hit the headlines even more recently for being volatile due to the Russia-Ukraine conflict.
With sanctions imposed on crude oil from Russia, oil prices are likely to continue increasing.
However, even before the Ukraine conflict, inflation and rising interest rates pushed up the oil price.
Rising prices and oil are interconnected — higher inflation pushes oil prices up, but more significant oil prices raise prices elsewhere since almost everything in the economy relies on oil.
It’s not always simple to figure out which direction the cause and effect run in, but it’s reasonable to expect oil prices to keep rising.
3) US Bond Rates Increasing
Bonds can be a good predictor of prices and inflation. The interest rates that bonds offer to investors partly depend on how much inflation a country is experiencing.
So the theory goes, with higher inflation, interest rates rise in response to compensate for the additional risk that comes with investing.
We can see this borne out with lower bond prices and higher yields (falling bond prices mean higher yields). Yet, lower rates are typically on offer in a low inflation environment like the one we’ve seen recently.
The bond yield curve (with bond maturity on the x-axis and interest rates on the y-axis) demonstrates this relationship. A steep yield curve suggests inflation, while a flatter curve indicates uncertainty.
Now the Fed intends to raise interest rates, and most people are expecting inflation, bond yields are likely to increase in the future.
We’ve already seen the effects of this. US Treasury yields have increased faster than forecasts, while the yield curve has flattened (suggesting uncertainty about whether rate hikes will be steep enough). Yields have reached 2% for the first time since 2019.
If you want to take advantage of the lower bond prices, consider investing in bond ETFs. A few for your watchlist include:
- NYSEARCA: XLF
- NYSEARCA: KIE
- NYSEARCA: SCHH
4) House Prices Declining
When interest rates are higher, it’s less appealing for prospective homebuyers to take out a mortgage because their monthly payments will be higher.
Less demand for houses should theoretically mean that house prices fall (assuming that supply remains around the same).
We’re yet to see the product of this so far, but as interest rates begin to change, a very different housing market is likely to form.
5) Stock Prices Decreasing
The higher interest rates are, the more expensive it is to borrow money. That isn’t just a problem for individuals but also businesses since they rely on borrowing to grow their operations.
Considering we’ve already been through a tumultuous period and we’re entering another one, this could spell tough times.
Bad news for businesses means bad news for their shareholders. Higher interest rates could be one reason (among many more) why the stock market has declined since the start of 2022, and it may mean the trend is likely to continue – at a minimum we can expect some big swings in prices and volatility.
Then there’s the fact that higher borrowing costs make it more expensive for consumers to spend money, which affects the businesses selling to the consumer.
Considering the prices of goods and services increase with inflation, people can now afford relatively less.
Plus, some individual investors may also get spooked by inflation and decide to sell their stock holdings, particularly finance-related stocks. That doesn’t necessarily mean it’s time to sell though — if you’re brave, you could try to “buy the dip.”
Final Word: Fed Signally Rates Increases
In summary, expectations for inflation and rising interest rates are likely to push the value of the US dollar and oil prices up while decreasing stock and house prices and increasing bond rates.
However, this is just a brief outline of possibilities based on the theory and the limited data we have so far.
With so much volatility in the world right now, it’s impossible to predict exactly what will happen a few weeks or months down the road. So, stay informed and take action accordingly.
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Disclosure: The authors and Career Step Up are not licensed or registered investment adviser(s) or broker/dealer. They are not providing you with individual investment advice. Please consult with a licensed investment professional before you invest your money.
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Tim Thomas / Timothy Thomas Limited hold no positions in the stocks, bonds, ETFs, mutual funds, forex, or commodities mentioned.
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