Interest rates might rise faster than expected – what does that mean for your money?

The idea that the US Federal Reserve could raise interest rates much earlier than anticipated has upset the markets. John Stepek explains why, and what it means for you.

The US Federal Reserve – the world’s most important central bank – released the minutes from its December meeting yesterday.

Suffice to say, markets did not like it one little bit.

The Nasdaq index fell by more than 3% – its worst single-day loss since February last year. The S&P 500 was down nearly 2%.

Why? As usual, it’s the threat that the punch bowl might be swept away.

Higher interest rates are hard to argue with but markets won’t like it

At its last meeting, the US central bank, the Federal Reserve, said it would reduce its money printing at a faster pace. It also implied that interest rates would rise more rapidly in 2022 than it had previously thought.

None of those things came as a surprise to markets at the time, and there wasn’t a massive reaction.

However, yesterday the Fed released the minutes of that meeting. Some of the thinking that went into the decision has made investors rather less comfortable.

Long story short, the minutes imply that the Fed thinks the US economy is strong enough to bring a halt to this period of emergency interest-rate policy. Indeed, interest rates could rise more quickly than expected.

And, really, who can blame them? Employment is strong. Omicron is a fly in the ointment, but it appears to be milder than previous variants, and we’re also getting to the point where we have to start thinking about how to live with this thing. And of course, there’s the small matter of inflation being at its highest level since the 1980s.

However, on top of that, some Fed members are even thinking about reducing the size of the Fed’s balance sheet. In other words, they would embark on QT – quantitative tightening – where they sell the US government bonds they own.

In theory, that implies higher interest rates, though in practice the relationship between quantitative easing and bond yields is a complicated one. But one way or the other it implies tighter monetary policy, and more importantly, a more hawkish mentality for the Fed than markets have seen for a very long time.

On the one hand, this is good news because it suggests that the Fed thinks the economy really is strong enough to warrant higher interest rates.

However, if you accept the premise that ultra-low interest rates are at least partly responsible for historically high (or record in some cases) market valuations, then it’s only logical to expect that tighter monetary policy will dent those valuations. And so that’s what we saw yesterday.

This fear has been rattling markets for a while

In fact, although yesterday saw one of the most headline-grabbing drops that we’ve seen in a while, the reality is that this process – the reluctant acceptance that tighter monetary policy is on its way, and that this is bad news for the hottest growth stocks – has been happening for a while.

The “buy-the-dip” mentality dies hard, but it looks to me as though that process is well underway. It’s not exactly grabbed headlines, but the most rate-sensitive parts of the market have collapsed already.

Cathy Wood’s ARK Innovation ETF, which is heavily invested in “jam tomorrow” stocks, is down 11% already this year. The “non-profitable tech index” from Goldman Sachs, which does just what it says on the tin, is down nearly 10%.

And as we noted earlier this week, the IPO boom of 2021 hasn’t translated into good returns for the investors in said IPOs.

So the Nasdaq sliding is more of a spreading of this rate malaise, rather than something new.

There are still lots of questions. This is a year of transition – how will it pan out? There’s an argument that inflation might moderate just as the Fed is raising rates. While I’m a long-term inflationista, I can see that this is certainly possible. But it’s hard to imagine getting to the point where inflation is so low that the Fed decides that it’s mission accomplished.

There’s a risk that rising rates cause a wider bear market, particularly if people start to worry about how governments will repay their debts. Would the Fed be happy to watch in silence if a proper bear market erupts and the Treasury market falls into turmoil? No chance. But by that point, your rate-sensitive stocks will be a lot lower than they are today.

We’ll just need to wait and see. So what should you do in the meantime? The same thing I always say – don’t panic and stick to your plan. We’ve been telling you to stick to cheap stuff, hold some gold, hold some cash, and to make sure you have a watch list so you’re ready to take advantage of any opportunities you spot.

I’d stick with that. If we get a “proper” sell-off, then it’s unrealistic to think that other global markets wouldn’t get swept up in the turmoil.

But some companies will survive and even thrive in either an inflationary or even a stagflationary environment – and most of those are likely to be numbered among the ones who have struggled during this ultra-low rate environment.

So stay calm, stick to your plan (or get a plan if you haven’t already got one), and let’s see how things unfold from here.

(Probably not a bad time to subscribe to MoneyWeek magazine as well – six issues for free, right here).

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