The Federal Reserve is set to raise interest rates at its May meeting after it hiked rates for the first time since 2018 in March. The nation’s central bank is expected to lift the benchmark Fed funds rate by 0.5 percent, according to the CME FedWatch Tool.
It’s likely not the last increase for the year, either. The odds are high that the Fed will raise rates several more times this year as it attempts to get inflation under control.
These potentially higher rates could play out on stocks, cryptocurrency, commodities (such as gold and oil), as well as many other investments over the rest of this year and into 2023. But what can investors expect and how long will the rising rate environment impact markets?
Prospect of higher rates pressuring the market
While the Fed has raised rates just once this year, it’s easy to spot when markets really sat up and took notice that the central bank wasn’t kidding that it was about to tighten monetary policy. It was November 2021 when cryptocurrency and many of the riskiest stocks peaked.
“The stock market is forward looking, so just the expectation of higher rates has had an impact,” says Caleb Tucker, director of portfolio strategy at Merit Financial Advisors in the Atlanta area.
Still, the broad-based Standard & Poor’s 500 Index closed the year out near its all-time highs. From there, though, it’s been mostly downhill for the index, and more so for riskier investments. It’s been a similar situation for the Dow Jones Industrial Average and the Nasdaq Composite.
“From the beginning of 2022, stocks have pulled back and interest rates moved higher in anticipation of coming Federal Reserve interest rate hikes to corral inflation,” says Greg McBride, Bankrate chief financial analyst.
The S&P 500 is down about 12 percent since the start of the year, while the tech-heavy Nasdaq Composite is down even more, 20 percent, and the Dow Jones Industrials are off 9 percent or so. Still-riskier investments have fared much worse, and the declines show few signs of slowing.
“Assets that have benefited most from ultra-low interest rates – think high-octane growth stocks with earnings well off into the future and non-cash-flow-generating assets like cryptocurrencies – have been most susceptible to a pullback given the prospect of higher interest rates,” says McBride.
For example, high-growth tech stocks such as Cloudflare and Carvana have fallen about 60 percent and 80 percent, respectively, from their 52-week highs just a few months ago.
Will rising rates and inflation derail stocks in 2022?
Stocks, cryptocurrency and commodities have endured notable volatility in the last few months as investors have factored in rising rates and, in the last few weeks, the Ukraine-Russia conflict. But what’s in store for the rest of the year, with the prospect of multiple rate hikes and even the distant possibility that the Fed must really jack up rates to fight stubbornly high inflation?
With less money sloshing about in financial markets, that’s a net minus for investments as a whole, but investors have a notable habit of looking beyond today’s news.
“Rising interest rates will always trigger a period of stock market volatility,” says Dan Raju, CEO of Tradier, a brokerage platform. “The fact that the Fed has indicated multiple increases means that we are going to have a year of continued volatility.”
But that volatility can be short-lived if the underlying economy remains strong, as it is today.
“Historical data and trends of the Nasdaq, Dow and S&P 500 show that the market tends to recover in about three weeks,” says Raju.
But market watchers are divided as to whether the Fed will do too much or too little and whether that’s already priced into stocks. This uncertainty itself drives volatility in the markets.
“Elevated volatility tells us that there is a fair degree of pessimism already baked into the markets,” says Craig Fehr, principal and investment strategist at Edward Jones. “This doesn’t eliminate the possibility for further near-term weakness, but it does tell us that a good portion of the risks are already reflected in the current stock market correction.”
Fehr notes that a correction – a decline of at least 10 percent from recent highs – doesn’t usually become a bear market as long as the economy is growing. He thinks the Fed may not have to raise rates as aggressively as some expect, leaving room for markets to move higher.
“Higher rates will, in our view, drive lower valuations, but we think earnings growth will remain sufficiently positive to support positive, but more moderate, stock market gains this year,” says Fehr.
McBride suggests the market is somewhat optimistic about the Fed’s ability to tamp down inflation, potentially creating further risk if it doesn’t do so.
“Markets are priced as if inflation will prove to be transitory and the Fed can engineer a soft landing of raising interest rates without triggering a recession,” says McBride. “I’m not sure the downside risks are fully appreciated at this point, but that will come into clearer focus if the Fed continues to raise rates and inflation remains stubbornly high.”
In this latter case, markets may have to re-adjust to more aggressive rate hikes until the Fed does get a handle on inflation and reins it in, meaning the rest of 2022 will likely remain rocky.
That means you can expect volatility to be the name of the game for the time being.
How will higher interest rates affect crypto and commodities markets?
Two other major asset classes have had varied responses in the face of higher rates. While cryptocurrency prices have plummeted along with other risky assets, many commodities have spiked higher, including oil, wheat and nickel. Will these moves prove short-lived?
Cryptocurrency has often been touted as a cure-all for what ails you, whether that’s inflation, low interest rates, lack of purchasing power, devaluation of the dollar and so on. Those positives were easy to believe in as long as crypto was rising, seemingly regardless of other assets.
“Crypto assets had been seen as an inflation hedge, but recently they have acted more like other risk assets such as stocks,” says Tucker. “Higher rates will be a headwind for crypto assets going forward.”
Indeed, cryptocurrencies have responded to reduced liquidity as did other risky assets, by falling when the Fed announced in November it would begin tapering its purchases of bonds and signaled higher interest rates were soon on the way.
While Raju acknowledges that crypto assets will certainly feel the headwinds of higher rates, he anticipates an up year. “I strongly believe crypto will be a net positive in 2022 because any short declines driven by rate hikes will be offset by greater institutional and retail active trader adoption of this asset class,” he says.
The prices of some commodities have skyrocketed recently, a move that could potentially complicate how fast the Fed raises interest rates.
Some of those increases can be tied to the Russian invasion of Ukraine. For example, oil prices shot through $100 a barrel in the early days of the conflict and even ran up to $130. Meanwhile, wheat futures surged from $8 a bushel to more than $12. The price of nickel more than doubled in a day, as fears of supply disruption initially propelled the market higher.
“With the jump in wheat futures, investors are trying to capitalize on rising wheat prices,” says Anthony Denier, CEO of trading platform Webull. “However, this will also raise the prices of products that use wheat. So this will have repercussions for a lot of food companies.”
The question for many, though, is how long and sustained the prices of commodities will remain.
The Russia-Ukraine conflict
The Russia-Ukraine conflict is also rattling markets and could potentially affect the pace of the Fed’s moves, especially if it leads to persistently high prices for oil, wheat and other commodities. High oil prices could quickly ripple through the economy and raise costs on other products, too.
“The Russia-Ukraine crisis could further contribute to already high inflation due to fears that prices for oil and other raw materials will continue to spike,” says Raju. “This may force the Fed to further tighten interest rates even if growth slows.”
A deepening of the crisis could extend the length of any supply-chain disruptions, exacerbating inflationary pressures and complicating the Fed’s mandate. And because energy prices affect a broad range of the economy, higher prices can quickly ratchet up overall inflation.
How should rising rates impact your investing strategy?
Rising rates, spiking inflation, international conflict – they all create a stew of volatility for investors. But those risk factors may be overshadowing strong economic fundamentals, at least in the U.S. For example, consumers are ready to get out, travel and spend some of the cash they’ve hoarded for the past two years – and that could bode well for travel stocks.
“All focus is on the Fed and now Ukraine,” says Tucker. “Both factors deserve our attention, but the labor market is exceptionally strong and economic fundamentals drive returns over the long term.”
McBride points to a solid economy, growing corporate earnings and low unemployment as notable strengths. “Those fundamentals are positive for stocks in the long run, but it will be a bumpier ride in the short term with interest rates moving higher,” he says.
With those strong fundamentals, the best way for most investors to approach this type of market is to stick to the long-term game plan. For many, the long-term plan means continuing to invest regularly in a diversified portfolio of stocks or bonds, and mostly disregarding the noise around the world. For others, the game plan may involve buying and holding well-diversified index funds. Either way, it’s not a time to let emotions get in the way of an effective long-term investing plan.
While short-term traders may be sweating rising rates, it’s vital to keep things in perspective. Rates typically rise when fundamentals are strong – and stocks tend to do well in those times, too.
“Yes, markets will recover and can actually perform relatively well during periods of rising rates,” says Tucker. “Many different studies show how average returns for stocks during periods of rising rates are similar to long-run average returns.”
So instead of trying to find the right time to sell, buy-and-hold investors can use the market’s volatility to their advantage and then try to find the right time to add more.
“For long-term investors, the pullbacks represent attractive buying opportunities,” says McBride.
Downturns can be an attractive time to add to your portfolio at discounted prices. As investing legend Warren Buffett once said, “You pay a very high price in the stock market for a cheery consensus.” That is, stocks are cheaper when few agree that they’re an attractive investment.
Interest rates are poised to rise in 2022, and the big question right now is just how high they might go. With strong fundamentals underlying the economy, investors with a long-term investing horizon may view it as an ideal time to pick up some quality investments at bargain prices.
And if prices continue to plummet? Buffett has some wisdom for that situation, too: “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”