DISCLAIMER: The views expressed in this article should NOT be construed in any way as financial or investment advice. All views expressed are those of the author after conducting independent research. Any resulting investment decisions are taken at the reader’s own risk.
EDITORS’ NOTE: This article was originally drafted in April 2022 in response to the Federal Reserve’s March interest rate hike. However, the Fed’s most recent rate hike by a monumental 75 basis points has brought renewed significance to the insights shared in this article.
Author: Aaron Jun Kit Wu, Graphics: Bella Aharonian
The BRB Bottomline
The Fed has made headlines for increasing its interest rate to combat inflation. For average citizens and businesses, increased interest rates are usually a red flag. However, the Fed’s policy may have created opportunities for well-informed investors to generate a profit. This article explains how retail investors can make money despite increased interest rates.
Imagine you were given the opportunity to invest in the stock or real estate market with a buy-in price significantly lower than ordinary market valuations. It may sound too good to be true, but the Fed’s increase in interest rates may turn out to be an outstanding opportunity for investors to turn a greater profit than they would otherwise expect.
What is the Fed and Why Should We Care Now?
The Fed, or Federal Reserve Board, is the governing body of the United States’ central banking system. It establishes key monetary policies that seek to prevent and mitigate financial crises, as well as takes general measures to curb inflation and unemployment. The Fed’s interest rate, or the federal fund rate, is the interest rate that is applied when private banks loan and lend their excess assets to one another within a 24-hour period. When the Fed increases the interest rate, it becomes more costly for investors and businesses to access money on credit. This effect, in turn, motivates businesses to postpone investment projects, thus spending less and saving more. The decreased supply of money in the market then allows the inflation rate to lower, stabilizing the economy. On the flip side, when the Fed decreases the interest rate, it incentivizes businesses and individuals to spend and loan more. The increased supply of money flow in the market thus increases the activity of the overall market, stimulating the economy. On March 16, 2022, the Fed increased its interest rate by 25 basis points (0.25%) which was the first increase since December 2018—in the hopes that the change would suppress the current inflation rate of 8.6%, the highest since 1981.
Could Your Checking Account Take a Hit?
The simple answer is that it depends. If you decide to take out a loan, the increase will impact your checking account; if not, it has a lower chance of impacting your account. The seemingly obvious course of action in this scenario is to postpone any potential investment that would require a significant loan from a bank; however, it might not play out as expected for several reasons.
For example, if a middle-class family was considering closing on a real-estate property, they may follow through with their decision despite the presence of an increased interest rate on the mortgage that they would have to take out. It could be because they are not affected enough to the point where it would alter their decision to buy a new home–, or simply because they are unaware of how the increased interest rate affects their mortgage payments. One of the key objectives of the Fed increasing their interest rate is to dissuade investors from taking out loans to enter investments. Ideally, by increasing the interest rate, it incentivizes people to hold their money rather than spend it to cash in on more interest; conversely, it disincentivizes people from taking out loans because they would need to pay higher interest. In theory, an interest rate hike should discourage people from purchasing property via mortgage loans, but in practice it doesn’t always work out that way.
Not a Bad Time to Get Into the Stock Market!
As opposed to real estate, a decision to invest in equities could not be beneficial unless you are financially stable. Why? If you invest without a significant cash reserve and are unsuccessful, not only would you have to take out a loan or put yourself in debt to keep up with living expenses, but the interest rates charged on these loans will be substantially higher than the corresponding rates before the Fed hike. This would result in higher potential debt and a more challenging process to repay your dues.
On a brighter note, if you are a potential investor with an excess supply of cash and are potentially looking at purchasing stocks, investing now would be ideal. When the Fed increases its interest rate, two things cause stock prices to drop. Firstly, with increased interest rates on loans, companies will be more reluctant to make new investments—leading to a decrease in the valuation of their stock. Secondly, retail investors will be fearful of the sudden decrease in the supply of cash and potentially feel compelled to liquidate a portion of their investment portfolio in order to maintain a safety net of cash on hand.
For someone with excess cash, the undervalued stock prices can help them turn a profit.
Historical evidence suggests that most stocks eventually bounce back to their original price after an initial slump. An example of this behavior can be seen with the Dow Jones Industrial Average. After the interest rate increase in December 2018, its valuation plummeted 15.67% from its peak of $26,743.50.
However, compared to the value of $26,616.71 that it was trading at its peak in 2018, the Dow Jones Industrial Average rebounded to $34,921.88 as of April 2022. This recovery from the initial slump caused by the interest rate reinforces the idea that stock values are highly robust and likely to be revitalized as the market recovers. The reason for this phenomenon is because when the Fed decreases its interest rate, companies and individuals are more willing to spend their cash on investments as there is a larger supply of cash and lower interest rates associated with loans. As a result, companies would be enabled to spend more on investments, allowing for company growth, and investors would be allowed to purchase stock shares. Both these factors lead to a greater stock price. This idea can be generalized to almost every other scenario involving a Fed’s increased interest rate as the government will eventually step in to ensure that the market is not in a perpetual slump.
The Only Thing One Really is Interested in: Profit
Ironically, someone can only make money in response to the Fed’s interest rate hike when they already have money to begin with. In other words, investing after the Fed increases its interest rate should only be a viable option for an individual if they can comfortably cover their living expenses with room to spare.
The Fed’s increased interest rate correlates with a decreased supply of cash, meaning that companies will be less likely to make large investments or ventures requiring cash. Furthermore, investors will likely be more cautious due to the lack of cash supply. These factors in conjunction will likely lead most stock prices to decrease. However, previous data suggest that despite dips in stock prices, the market tends to return to its original trading price after a period of time. As such, if you are an investor with a sufficient supply of cash, investing in the stock market when the stock prices have decreased due to the Fed’s increased interest rate can all but ensure a profit in the long run.
With regards to making loans, there are many factors to consider when purchasing a home after the Fed’s increased interest rate. However, the factors that have to be remembered when making the decision include:
- Loan prices for a house will be higher due to the decreased supply of cash.
- Real estate prices tend to be largely unaffected by the Fed’s increased interest rates.
- It is important to remember that a real estate venture for average investors is a substantially cash-heavy decision that shouldn’t be rushed.
Overall, the Fed’s increased interest rates can lead to potential opportunities to profit in the stock market and the real estate market. While the real estate market is more complex to navigate than the stock market in the event of an interest rate hike, the one key idea to take away is to avoid loans at all costs—the decreased supply of cash makes loans harder to acquire, and banks will increase the interest rates at which they are given. The overall consensus for equity investments is to only consider entering the market if you have enough cash to sustain your living expenses for an extended period of time.
- The Fed’s increased interest rates lead to a decreased supply of cash, meaning that loans would be harder to acquire.
- Investing in the stock market after the Fed increases its interest rates is highly likely to yield profit as you are buying at a low point which is almost guaranteed to return to its trading price prior to the dip.
- Real estate prices tend to be unaffected when the Fed increases interest rates; however, the interest rate to acquire a loan would be higher.