It’s amazing what rapidly rising interest rates can do to the financial world. Markets rise and fall like a ship on the high seas, with everyone on board warily looking ahead for what just might be that fatal iceberg.
It’s not surprising then that many investors go into defense mode at the first hint of interest-rate hikes. They look to protect their previous gains by selling off equities and moving to cash, commodities, or whatever instrument they believe will be safe.
And indeed, exercising caution when interest rates run amok is a sound move, but don’t go burying your cash in your backyard just yet. Rising interest rates also present some great opportunities for the savvy investor.
Go Equity Bargain Hunting
If you’re a patient investor with the ability to lock up some capital for a few years or more, rising interest rates can present you with some excellent buying opportunities in the equity market.
Interest rates can’t rise forever, and when things return to normal, so too should the valuations of your favorite companies. Look for solid companies on firm financial footing (lots of cash) that can ride out a prolonged economic downturn, in case that’s where we’re headed. You’re looking for stocks that have lost value due to macroeconomic issues, not company-specific issues. These companies almost always bounce back, and when interest rates are rising, you can buy them at a deep discount to their actual worth.
If you want to be aggressive, look for companies that are not curtailing their research and development (R&D) departments. A lot of companies act fearfully in the face of uncertainty and focus on cutting costs rather than funding expansion and innovation. The companies that have the financial ability and discipline to keep looking forward are the ones that will come out on top.
Start Trading Forex
Trading forex might be one of the riskiest ways to capitalize on higher interest rates, but it could also be the most profitable. Interest rates are often the biggest factor in determining a currency’s value, so when interest rates are rapidly moving, so too are the values of currencies relative to each other.
A quick glance at daily rates of the euro to the dollar (EUR/USD) bears this out. In 2021, the currencies only moved more than 1% relative to each other on one trading day. In 2022, as interest rates began to significantly move, the EUR/USD swung more than 1% on more than 20 trading days in the first nine months alone.
One percent swings might not seem significant, but forex traders often trade on margin, allowing them to turn small price movements into significant gains. Ride out a few winning trades in such a volatile market and you’ll soon find yourself in a higher tax bracket.
Of course, interest rates aren’t the only factor in determining exchange rates, so forex traders have to keep an eye on a number of other variables.
Participate in the Bond Market
If you’ve ignored bonds over the last few decades and just focused on equities, you probably don’t have many regrets. Since 2003, the S&P 500 has only posted negative yearly returns three times. But now, as inflation pushes up interest rates and stocks tumble, it might be a good time to pivot to the bond market.
Certain segments of the bond market are great for protecting your money in the face of high interest rates, particularly I Bonds. What are I Bonds? I Bonds are issued by the US Treasury and pay out a set interest rate plus a rate that is adjusted for inflation. In times of high interest rates and inflation, their yields can approach 10%. You can’t sell them for at least a year after purchase, but you know your money will be safe and earning a decent return.
Similar to the equity market, a lot of bargains can be found in the corporate bond market when interest rates are high. Interest-rate hikes hit bond prices directly, but it’s important to remember that not all corporate bonds are created equal. Long-term bonds issued by companies with solid balance sheets might be near historically low price levels.
Assess Your Liabilities
This is also a good time to take a good look at your own liabilities. How do rising interest rates affect your mortgage? Your credit card debt? Other loans?
If, for example, you have an adjustable-rate mortgage, your payments might increase significantly as interest rates rise. If that thought is keeping you up at night, it might be a good time to refinance and lock in an interest rate today before rates go even higher.
Switching to a fixed-rate mortgage takes out all the guesswork, so you don’t have to worry that further interest-rate hikes will price you out of your own home. If and when things settle down and interest rates return to the lows we’ve seen over the past 20 years or so, you can always refinance again at a lower rate.
You also have to be wary of your credit card rates, which banks are extremely eager to hike. Funny how they don’t react quite as fast when determining the interest on your savings account.
If you’re carrying credit card balances over from month to month, pay them down before you dedicate that money to any investment vehicle. Paying off debts rather than paying 20% or more interest will probably save you more money than you’d earn in any market.
Rapidly rising interest rates can create a difficult environment for investors, to be sure, but it is always beneficial to keep both your mind open to potentially lucrative opportunities. That doesn’t mean throwing your money into markets you don’t understand, however, so be sure to do your homework before you act.
About the Author
Michael Diamond worked in commercial banking for more than 30 years before retiring to trade forex and continue his mission of helping expand the financial literacy of anyone who is looking to learn.