The Federal Reserve just raised interest rates again, bumping up its short-term lending rate by a quarter-point on Wednesday, to 1.5%. It’s the third time the central bank has inched rates higher this year — and any time it does, it’s a closely watched and deeply analyzed move.
So why do investors turn Fed-watching into a spectator sport?
The Fed raises rates when it sees higher inflation due to a stronger economy. That usually correlates to lower unemployment and flusher pockets. When rates are rising, people have jobs and wages tend to go up. Consumers are out spending money, enjoying life and pushing up inflation.
It’s good times, in other words — but investors can be a nervous lot, always looking to the future.
Why rate increases make investors nervous
Investors closely watch the Fed because the nation’s central bankers determine interest rates, and those rates determine how cheaply companies and individuals can borrow. In other words, the Fed determines how much money costs.
Cheap money is great for businesses, allowing them to borrow more and expand. And it’s great for investors, too. They can borrow more easily to buy stocks, and cheap money means investors will value companies more highly in the stock market, so stocks rise.
But when the Fed raises rates — even modestly, as it has done in 2017 — investors begin to get antsy. They worry about how much more rates will increase, and when. At some point, those higher rates make stocks and bonds less attractive investments, and investors want to sell before those assets decline in price.
Investors are expecting three or four rate increases in 2018, suggesting expectations for rising inflation and strong economic growth in the year ahead.
So it’s not unusual for investors to be knee-jerk sellers when rates rise. But when there’s room for the economy to expand — when inflation and wage growth remain low, like now — selling can be exactly the wrong move for building long-term wealth.
Why you should pay attention — but not panic
Don’t be a knee-jerk investor when rates rise. Rising rates are a sign the economy is improving; people are spending, and well-run businesses are making money and growing. A small increase in interest rates isn’t going to change that. And rising interest rates aren’t going to change the fact that people will continue to buy the goods and services they want and need. So money is moving through the economy more briskly, which is a net positive for stocks.
Still, you should be aware of what’s going on with interest rates, if only because it provides insight into how the economy is performing. When rates have gone up for many years in a row, it can be a sign the economy is topping. For now, the U.S. economy isn’t very far into this cycle of rising rates.
Regardless of where rates are going, find great companies and continue buying them, and buy more when they’re cheap.
Eventually, the Fed raises rates enough to tamp down inflation, and the economy no longer expands. It’s usually not too long until the economy declines, and in order to keep the economy from crashing hard, the Fed may lower rates. Lowered interest rates are your signal that the economy is usually moving toward a recession.
How to use the Fed to your advantage
How the Fed moves interest rates is a good signal of how the underlying economy is performing. As an investor, you should watch this and use it to your advantage, but don’t get fooled into playing the short-term trading game of professional investors. If the market sells off on interest rates while there’s room for the economy to expand, it could be a time to jump in and buy more.
For now, investors are expecting three or four rate increases in 2018. That suggests expectations for strong economic growth in the year ahead and rising inflation.
Regardless of where rates are going, though, find great companies and continue buying them, and buy more when they’re cheap. Or if you’re an index investor, continually add to your funds and buy more when the market declines. Then you really are taking advantage. Invest for the long term, and forget whatever freakout the market has about interest rates.