How to invest and profit in a rising interest rate enviroment

After 34+ years of declining rates, you now believe that interest rates are finally going to start increasing. After all, the Fed Funds has begun its interest rate hike march as of December 2015. But a rising Fed Funds rate in 2016 and beyond does not necessarily mean rising interest rates for consumers e.g. mortgages.

I’m in the camp that interest rates will stay low for years to come because of the following reasons:

* Information efficiency
* Economic slack
* Contained inflation
* Coordinated Central Banks
* The growth of China and India and their continued purchasing of US debt
* The growing perception that US dollar denominated assets are the safest assets in the world
* A 30+ year trend of declining rates that is telling us we’re more adept at managing inflation with each new cycle that passes

But let’s say I’m wrong. Let’s say rates start rising aggressively? Where should one invest? What else should one do? To answer these questions, let’s first look back at history and get smart!

HISTORY OF FED FUNDS RATE AND 10-YEAR YIELD

As you can see from the chart, I wasn’t lying when I said interest rates have been coming down for over 30 years now. Primary goals of the Federal Reserve are to contain inflation, promote orderly growth, and provide maximum employment. The Fed usually assigns an inflation target, which currently stands at 2%, and adjusts interest rates, prints money, or buys back debt to reach such a target.

Since about 1984, inflation rates (green) have hovered at a manageable 1-6%, with a downward trend. As a result, the 10-year Treasury and the Fed Funds rate have followed lower as well. When money is cheap, people tend to borrow, invest, and spend more. This causes inflationary pressure. But based on how inflation has been acting, rates are in their appropriate place.

Another thing to notice in the chart is how the Fed Funds rate (red) is much more volatile than the 10-year treasury yield (blue). The Fed Funds rate is controlled by a committee of people from around the nation. The 10-year yield is dictated by the Treasury bond market. There is good correlation between the two, as is evident in the early 1990s. But notice how the correlation starts to loosen since 2005. In other words, we could see a large increase in the Fed Funds rate at 25 bps each hike, and the 10-year yield (the market) may still stay relatively flat.

OK, now that we’ve got some historical perspective on inflation, the Fed Fund rate, and the 10-year Treasury yield, let’s look at how interest rates and the S&P 500 have correlated.

The interesting thing about this chart is that whenever there is a recession (grey columns), the Fed has cut interest rates to help spur economic growth and employment. The Fed seems to OVER cut rates compared to the decline in the 10-year yield, and therefore has to hurry up and raise rates five years later.

If history is any guide, there is a high probability that the Fed will start raising rates at the end of 2015, and for the next several years as inflationary pressure builds up. The stock markets are all at record highs, housing is making a strong comeback, and the US unemployment rate is at 5.1%. All factors point towards higher inflation. Too much inflation is bad for buyers of goods like housing, food, clothing. Inflation will be the biggest cause of war between the haves and the have-nots.

But here’s the thing. Even if the Fed jacks up rates from 0.25% to 2%, the 10-year yield will probably increase by LESS than the 1.75% increase. Why? Because the 10-year yield is dictated by the market, and the market still won’t believe in aggressively higher long-term inflation given the 30+ year downward trend. Just look at the Fed Funds Rate from 2004-2007. The move up was huge, yet the 10-year yield stayed relatively constant.

The 10-year yield is more important because it is a much stronger indicator for borrowing rates.

A RISING INTEREST RATE ENVIRONMENT

Inflation is very close to the Fed inflation target zone, which means rate hikes are an inevitability

Let’s say you’re still convinced that borrowing rates are going to skyrocket because the US carries too much debt, and we need to raise interest rates to entice foreigners to help pay off our debt. This is an argument that some have advocated, but which I don’t buy because foreigners are already buying US debt hand over fist due to the desirability of US assets.

Let’s look at the losers and winners of a rising interest rate environment.

Losers In A Rising Interest Rate Environment

• High Yielders: As interest rates rise, existing yields look relatively less attractive. Let’s say investors have been buying a REIT or AT&T mainly for their 5.5% yield. If the 10-year yield rises from 2% to 6%, investors would logically sell the REIT and AT&T and buy a risk-free 10-year bond that provides a higher yield. Dividend stocks, REITs, Master Limited Partnerships, and Consumer Staples will likely underperform.

• Highly Leveraged Firms: If you’ve got a lot of debt, your debt servicing cost goes up with higher rates. Your risk of default also goes up. As a result, investors will sell highly leveraged firms at the margin. REITs, utilities, and any sector that commands high ongoing capital expenditure will likely underperform.

• Exporters: As interest rates rise, the value of the US dollar rises because more foreigners want to own USD denominated assets. You need to buy US dollars to buy US property, US stocks, US anything. An appreciating dollar will therefore hurt US companies who derive a large portion of their profits from the export market because their goods will be more expensive at the margin.

* Individual Debtors: Those of you with credit card debt, floating rate mortgages, student loans, and future car loan borrowers will feel a bigger pinch.

Have Student Loans? Check out SoFi to refinance them. SoFi is one of the leading new financial technology companies based in Silicon Valley that not only reviews your credit score and income/debt ratios, but also looks at the quality of your education and quality of your work institution. If you’re right out of school, you’ve got a lot of upside, but perhaps your finances don’t look so great at the moment. That’s where SoFi can really offer lower rates because banks and government lenders can’t look at individuals holistically. Check SoFi out for a lower interest rate.

Winners In A Rising Interest Rate Environment

In finance, everything is Yin Yang. The following are the relatively winners:

* Cash Rich Companies: If a company has no debt and plenty of cash, it will be perceived as less risky. The interest income from its cash will go up, and investors may flock towards these companies for relative safety. Having too much cash is not a good use of capital, so the longer-term fate of the company will partly depend on its capital efficiency. I’d look for companies trading at book value, or who have a huge percentage of their book value in cash.

* Technology and Health Care. Technology and Health Care are the opposite of high yielding companies. They utilize their retained earnings for growth. In the past 13 rising-rate environments over the past 64 years, tech and health care sectors gained an average of 20% and 13%, respectively during the 12-month period following the first rate hike of each cycle. This compares favorable to an average 6.2% gain in the entire S&P 500. Of course, a lot of the future performance in tech depends on where current valuations and expectations lie.

• Brokers: Brokerages, like Charles Schwab, earn interest income on un-invested cash in customer accounts. So when rates rise, they can invest this cash at higher rates. This is the crux of the big debate about Charles Schwab’s free roboadvisory service. The leading roboadvisors all balked that Charles Schwab really wasn’t free since they recommended 8-30% cash weightings, which Charles Schwab would then use to earn a revenue spread.

• Maybe Banks and Insurers: So long as there’s an upward-sloping yield curve, banks should benefit. That said, I just wrote that the Fed Funds Rate (short-term) could rise aggressively, and the 10-year yield (medium/long term) could stay flat. As a result, banks could see a decline in net interest margins.

* Shorter Term Duration and Floating Rate Funds. To reduce your portfolio’s sensitivity to rising interest rates you want to lower the average duration of your holdings. The Vanguard Short-Term Bond Fund (VCSH) is one such example where if you pull up the chart, you’ll see much more stability. Another idea is to buy a bond fund which has coupon rates which float with the market rate. Luckily, we also have an ETF for such a fund called the iShares Floating Rate Fund (FLOT). Treasury Inflation Protected Securities (TIPS) are another less sexy way to invest.

* Individual Savers. Retirees on fixed incomes or prodigious savers should rejoice with higher interest and dividend incomes. Relatively speaking, cash becomes that much more valuable as other asset classes decline. It’s good to have a healthy cash hoard to start legging back into equities and bonds once you’ve found your risk tolerance.

You can buy a Rising Interest Rate Motif that was professionally created and currently managed by the Motif Investing research team as well. They have several interesting ones to choose from. Check this one out and the massive outperformance of the S&P 500 (green line) over the past year!

RATE HIKES CAN BE POSITIVE FOR ALL

It’s important to differentiate between short-term moves with long-term implications. Rate hikes in the short-term may result in knee-jerk sell-offs in various sectors and stock market indices. But over the long-term, rate hikes should be viewed as positive because the Federal Reserve is theoretically trying to always act in the best interest of the US economy.

The Fed will only raise rates if they see signs of inflationary pressure. There’s only inflationary pressure if employment is robust thanks to strong corporate profits and consumer demand. In such an environment, anybody who has a job and owns assets is doing well. The virtuous cycle continues until there’s too much exuberance. The Fed wants to contain irrational exuberance that ultimately leads to massive asset price deflation. Nobody wants social unrest, rising unemployment, and years of financial pain that follows during a recession.

Summary of what to do when rates are rising:

* Reduce / avoid adding on future debt

* Refinance to a longer term duration mortgage.

* Increase cash weighting to increase interest income or to build a war chest for future investment opportunities

* Reduce weighting in higher yielding securities and increase weighting in growth securities

* Buy TIPs, a professionally created rising interest rate motif, or inverse bond ETF

* Consider selling / reducing exposure to your passive income investments

* Finally go on your European, Brazilian, or Asian vacation!