It’s a foregone conclusion in the markets that the Federal Reserve will raise short term interest rates on Wednesday. But more importantly, investors will be looking for hints for future rate increases.
Why is this so important? The consensus view is for 2-3 Fed increases this year, but anchoring into this expectation comes with risks. For example, in 1994 the Fed surprised investors by increasing rates 6 times, resulting in a 3% loss for bonds that year. Of course, bonds recovered in following years, thanks largely to the long-term trend of falling interest rates since 1981.
Many investors have the general understanding that fixed income prices move inversely with changes in interest rates. An increase in rates typically results in a decrease in value of the underlying fixed income security. However, many investors are uncertain about the relationship between interest rates and equity markets.
Over the past year, investors have been attentively watching for when, or if, the Fed will raise rates. The Fed has stated its plan to raise rates slowly to avoid derailing previous economic gains. Before assuming that rising rates will detract from the overall health of the economy, let’s focus on how rising rates will affect your portfolio’s allocation to equities.
It is important to understand why the Fed is preparing to raise rates. The Fed has been very accommodating to the economic recovery by holding rates at historic lows. The Fed is not raising rates with a goal of slowing down the economy, but rather to get back to a more “normal” level.