Should Rising Interest Rates Impact Your Investing Strategy for 2022?

With the Federal Reserve set to begin its gradual interest rate hike this year, should this impact how long-term investors approach the stock market? In this segment of Backstage Pass, recorded on Jan. 26, Fool contributors Rachel Warren, Connor Allen, and Jason Hall discuss. 

Rachel Warren: The Federal Reserve released the results of its much-awaited two-day meeting earlier this afternoon. Stocks rose after the Fed released the outcome of the meeting temporarily and then tumbled shortly thereafter and mostly closed the day down or flat.

One of the things that was most prominent from their announcement, they said, "The committee seeks to achieve maximum employment and inflation at the rate of two percent over the longer run. In support of these goals, the committee decided to keep the target range for the federal funds rate at zero to one-quarter percent. With inflation well above two percent and a strong labor market, the committee expects that will soon be appropriate to raise the target range for the federal funds rate."

In short, an interest rate hike could becoming as soon as March. But the Fed is keeping the exact timeline close to the vest. Investors should expect to see a quarter percentage point increase soon. As CNBC reported, "there were only indirect statements about when the Fed might end its monthly bond buying program and start reducing the bond holdings on its balance sheet."

CNN also reported "asked about the potential for a half point rate hike this year. Powell declined to commit one way or another."

Needless to say, investors were less than enthused. I want to hear, what's your reaction to the outcome of this meeting? Were you surprised the Fed didn't release an exact timeline? Do you think this is a good or bad thing for stocks? Are you going to be changing anything about how you invest based on this information? Connor.

Connor Allen: I'm not changing anything. Obviously, uncertainty without an exact timeline is never really good for stocks, at least historically. But what you're going to see from this meeting, you look at the CNBC article and the quotes that you see are going to be talking about how Powell might be taking a more aggressive approach, or at least he's not opposed to taking a more aggressive approach.

They take out the most extreme quotes from the entire meeting. I think it's always important to go and actually, if you're really interested in this, I don't think I've ever listened to an entire Fed meeting before. [laughs] Doesn't seem like a good use of my time.

But overall, I'm not too concerned about anything that they are doing. I think that Powell is doing a good job trying to maintain the health of the economy, and obviously, the way that I invest is not going to change based on this meeting or the uncertainty from it.

Warren: Jason.

Hall: Struggling to find the mute button here. [laughs] Connor, that's the perfect answer. I think a couple of things. If you're a person or a business operator and then you're thinking about taking on some debt, maybe you need to be paying attention to this to think about making sure you maximize your cost of capital to act quickly.

If you own a lot of bonds or you're looking at fixed income, you're thinking about the implications for debt that you might own, that you might be. Maybe you've got some bonds that you're thinking about selling and that's how you're going to raise cash in retirement. You might want to be paying attention because it's more directly material.

I think there are also implications you have to be aware of, generally. There is a relationship between stocks, especially growth stocks, and interest rates. Because the bond market is 10 times larger than the stock market, the debt market is gigantic. It's absolutely huge.

That means that if interest rates continue to move up and once they pass a certain threshold, there's money that's in stocks that moves to bonds because it can get a safer yield and that yield is enough to de-risk. I think we've already seen some of that happen over the past few months. That's because not as much about interest rates increasing, but the de-risking part of it. Investors will not pay as high of a multiple for growth when interest rates are higher.

That's a real thing, and what that could mean is that you need to reset your expectations about what sort of returns can stocks generate over the next three, five, 10 years. One of our north stars is always to outperform the market. If we can't beat the S&P 500, if we can't beat the Nasdaq-100, why are we doing this? [laughs]

Why are we putting in all of this time and energy and effort if we can't outperform whatever the benchmark index is? Sure, it's fun, and there's scratching that intellectual itch, all of those things that are healthy and good. But at the end of the day, it's about making money and reaching financial goals.

But sometimes, I think we lose track with what is a reasonable expectation for stocks to generate in terms of return. The 14%-plus in annualized returns we've gotten over the past decade, that's a lot better than the 10% long-term average. Are we going to continue getting 14%?

Or is it going to be 5% or 8% over the next 10 years? Reset your expectations around that, I think that's really important. Make sure your expectations aren't messed up, and what you think you can generate from your portfolio, and thinking about things like the Fed minutes and what they're talking about with interest rates and inflation and all of that kind of stuff and tapering off their bond-buying and all that.

It does have implications, but it's thinking more long-term about what they mean.

Warren: Yeah. Well, and the interesting thing is the way that they are doing it is the slow and gradual increase. We can look back over the history of the market to see, how has it responded when we've seen variant kinds of policies from the Fed about the way that they raise interest rates?

Historically, when these cycles have been on the slower side, while there has been more stock volatility as noted in a recent report by Schwab, the stocks have, although they've been more volatile, they've also done better than in periods where the Fed just sped up those rate hikes.

We might see more volatility. But the way in which they are implementing these slow but gradual rate hikes, I think is not only designed to not plunge us into a recession, but also to mitigate the outcomes that we might see on a variety of stock sectors.

I was a little surprised they didn't give a little more concrete details. But I think stocks could have reacted negatively to that as well if they had.

It's not changing anything about how I invest. I think it's something to pay attention to though, and we will be seeing how that plays out in the months ahead.

Hall: I'm going to share one more thing, it's going to take 10 seconds, I promise I'll be fast.

Warren: Go ahead, go for it.

Hall: This is the number they are talking about, the target federal funds rates, upper limit. Right now, it's at 25 basis points, which is where they're saying they're going to stay at.

Every 25 basis points is 0.25% is what it's worth. We're here. Rates started to go up at the end of the Obama administration through the Trump administration before getting slashed during the pandemic.

But it's actually been very low for a long time, and this is the big thing. Think about less than 2%. Even if it does keep going up, let's say we do get 25 basis points a quarter for the next two years. That's still going to put us below the long-term average.

Warren: Thank you for sharing that.