Higher Interest June 2022 marked 12 months characterised by a 9.1% rise in consumer prices. This is the largest increase in four decades, as reported by the United States Labour Department. Whenever inflation strikes, various segments of the market are on the receiving end.
Inflation can put investors in a tight corner, particularly those who are less experienced in the stock market. It has several negative effects on trading, a reason why every trader needs to devise a strategy for making profits amid tough times. The basis of such a strategy would be to know how interest rates impact stock markets.
The risk of higher interest rate
On balance, the interest rate and stock market tend to pull in different directions, assuming all the other factors of the stock market are constant. The effects of a change in interest rate may take even years to be felt in the economy, but the stock market reacts instantly. It is all about stock investors and their predictions about the market performance.
Immediately after the central or federal bank announces a hike in interest rate, a domino effect swings into action leading to increased bank charges. Credit becomes more expensive and the spending power of the population weakens. With people taking fewer loans and having to pay more for credit, their disposable income also reduces.
The higher cost of credit doesn’t exempt anyone, even public companies. Current debt also becomes more expensive. With disrupted repayment schedules, the profits of companies could be affected, and ultimately, the share price could fall.
So what can one do to shield trading from the risk of a higher interest rate?
Go for Value Stocks Instead of Growth Stocks
Value stocks refer to companies whose current stock value is below the perceived value. Investors believe that value stocks have been undervalued in the current market. Growth stocks are what the investors believe will offer extraordinary returns in the future.
Value stocks tend to perform better when the interest rate is higher compared to when it is lower. This is different from growth stocks, which become more popular during periods of low rates. You may have noticed this trend a couple of years ago when growth stocks were notably popular.
Value investing would mean going for stocks in companies with a steady income, stronger cash flows, and trading at below their intrinsic value.
Reduce Holdings in Gold And Oil
Gold and oil are extremely sensitive to higher interest rates, especially in the United States. Some experts believe that something like gold tends to go to the lower side amidst higher interest rates because higher-yielding investments heighten their competition. This special correlation between gold and interest rate has been evident many times, for instance during the interest rate hike in January this year.
Given the inverse relationship between these commodities with the interest rate, it would be prudent to minimize holdings in them when the rates rise. Again these trends have been evident in the past, even during the covid-19 pandemic season.
Apply Certificates of Deposit (CDs) Ladder
A third and equally effective strategy to shield your trading from higher interest rates is called CD laddering. This is an interesting saving method whereby staggered maturities are applied on various certificates of deposit to optimize higher interest rates for longer-term certificates of deposit. This strategy allows the investor to still enjoy the benefits of long-term investment and redeem their funds more frequently.
There is a lot of flexibility in building a CD ladder. For example, the CDs don’t have to be in one bank or of the same amount. The investor can shop for CD rates however he/she wishes. Yes, CD rates are typically low, but this strategy offers benefits like easy access to money and a guaranteed rate of return.
Outlook and Conclusion
The relationship between interest rates and stocks may be a little skewed, but the movement is usually inverse. Hopefully, this coverage gives an idea of how to shield your investment when the interest rates are higher.