Fed_Rate-Hike_Cycle
00:00:00.000 | Hello everybody, it's Sam from Financial Samurai. So the Fed has finally hiked rates on March 16,
00:00:06.480 | 2022. This is the first time since December 2018. And in this episode, I want to talk about why Fed
00:00:13.360 | rate hikes will have little impact on borrowing costs over the next 12 months, and also how the
00:00:19.040 | stock market has performed during previous Fed rate hike cycles. First of all, I think we can
00:00:25.360 | all agree that the Fed is behind the curve a little bit, actually probably a lot given inflation. The
00:00:31.360 | last print was at 7.9%. The Federal Reserve's goal is to try to get inflation around 2%, 2 to 2.5%.
00:00:40.080 | And the other goal is to try to get the unemployment rate down to about 3.5% to 4%.
00:00:46.000 | That is the employment rate, which indicates full employment, because there's always going to be
00:00:51.200 | people unemployed at any given point in time. So yes, the Fed is behind the curve when it comes
00:00:56.240 | to hiking rates. And that's understandable. The Fed would rather be a little too slow in hiking
00:01:01.600 | rates than a little too fast in order to help our economy survive a pandemic. Put it another way,
00:01:08.000 | which would you rather have? Higher inflation and a stronger labor market, or lower inflation
00:01:14.000 | and a weaker labor market? So the former is usually preferred, which is why we are seeing
00:01:19.360 | elevated inflation at the moment. The median projection for inflation in 2022 by the Federal
00:01:25.360 | Reserve Board of Governors is 4.3%. Now again, we just had 7.9% print in February. So 4.3%,
00:01:34.480 | I don't know, let's see. Inflation really has to drop down in the second half of the year.
00:01:40.720 | And for 2023, they're expecting 2.7%. That also seems pretty suspect. 2.7%, that's almost back
00:01:50.000 | to the ideal inflation target that the Federal Reserve wants to have, wants to achieve. So I
00:01:56.080 | have my doubts. However, anything can happen over the next 12 to 24 months. The Federal Reserve
00:02:03.040 | was more aggressive than expected. They're talking about hiking rates in the six remaining meetings
00:02:08.640 | in 2022. And if they hike by 25 basis points, that implies that the Fed funds rate will be in the
00:02:15.120 | range of 1.75% to 2% by the end of 2022. And they also committed to hiking three more times in 2023,
00:02:24.400 | which implies the Fed funds rate will be at 2.5% to 2.75% by the end of 2023. Is this likely? It
00:02:33.920 | just doesn't seem likely. However, if inflation stays, let's say over 6% in 2022, and over 4%
00:02:40.720 | in 2023, the probability is more likely. So how do we consumers get affected by rising rates?
00:02:48.400 | Well, I don't think most Financial Samurai readers and listeners will get significantly impacted at
00:02:54.400 | all, because the rate increases are very gradual. A 25 basis point increase is 0.25%. And the Fed
00:03:02.480 | is talking about increasing every meeting and every meeting is every one to two months, right?
00:03:07.680 | So the increase is very gradual, and you know it's coming. So if you know it's coming, you can
00:03:13.120 | refinance your variable rates to fixed rates if you wish. Or you can pay down more debt more quickly,
00:03:20.000 | so you don't have to pay those higher rates. So I will commend the Fed, commend Jerome for
00:03:25.520 | telegraphing exactly what they plan to do over the next 12 to 24 months. This visibility is
00:03:31.680 | very important to set expectations for investors and for consumers and borrowers. And better yet,
00:03:38.800 | the Fed has been more aggressive than expectations. Before they hiked rates,
00:03:43.200 | the fund management community was expecting more like four rate hikes over the next 12 months
00:03:49.440 | at 25 basis points each, so 1% versus six rate hikes or 1.5%, right? So the Fed was more aggressive
00:03:57.200 | than expectations, but that sets expectations and that allows the Fed, that enables the Fed to stop,
00:04:05.440 | to pause if necessary if things change, because things are always changing.
00:04:10.160 | So how will Fed rate hikes affect credit cards? Well, unfortunately, credit cards,
00:04:15.040 | the average APR is about 16% to 17%. And credit cards are variable rates. So when the Fed hikes
00:04:22.240 | the Fed funds rate, credit card rates will likely go up in similar fashion. However, let's say you
00:04:28.720 | have $10,000 in credit card balance and your interest payment goes up by 0.25%. Well, that's
00:04:36.480 | a mere $25 a year, so you're not going to really feel it. Even a 1% interest rate hike is only an
00:04:41.440 | extra $100 a year on a $10,000 balance. And that is if you hold the entire balance all year. So
00:04:48.000 | presumably you're going to start being more aggressive in paying down that balance before
00:04:52.240 | you have to pay a higher interest rate. Or what I think you might want to do is look into personal
00:04:57.360 | loans. Personal loans, they don't sound very good, but the average personal loan rate is much lower
00:05:03.680 | than the average credit card rate. So the average personal loan rate is about 9%. The average credit
00:05:09.200 | card rate is about 16.5% right now. So that six and a half, seven and a half spread is significant
00:05:16.400 | to save money over the long term if you're having trouble paying down your credit card debt. Now,
00:05:21.200 | the other method I like to paying down credit card debt, well, to at least save on interest,
00:05:26.000 | is to just call your credit card company and ask, "Hey, I've never missed a payment over the past
00:05:30.560 | 6, 12, 24, 5 years. Is there any way you can lower my interest rate?" It never hurts to ask,
00:05:37.600 | so you might as well ask. In terms of how Fed rate hikes affect auto loans, well, not so much.
00:05:44.160 | Not so much because you're probably getting a fixed rate loan on your auto loan. It's usually
00:05:50.240 | three years or five years. So if you've got an auto loan, nothing is going to change. Now,
00:05:55.440 | if you want to get an auto loan, which I'm not a proponent of because you're buying a depreciating
00:06:01.600 | asset with borrowed money, that's never generally a good idea. But if you insist to do so,
00:06:06.720 | your auto loan rate will depend more on your down payment and your credit score. Yeah, the rate might
00:06:12.640 | go up a little bit, but these car companies and dealerships have plenty of ways to make a lot of
00:06:19.040 | money off of you in addition to auto loans. This is just a one way to get you to buy the car that
00:06:26.560 | you probably shouldn't have paid so much for. And if you look at used car prices, it's really
00:06:31.280 | interesting. The prices are up something like 30% to 40%. So if you leased a car three years ago or
00:06:37.200 | two years ago, you're probably well in the money. And the other thing to think about is, a lot of
00:06:43.440 | people are talking about how high oil prices may crush the consumer, right? Well, yeah, high oil
00:06:49.280 | prices stink, but it could be temporary. It's probably going to be temporary. But if your
00:06:53.840 | used car appreciated by 20% to 40% over the past two to three years, that really, I think, deflects
00:07:01.120 | a lot of the pain from paying higher gas prices. The average used car price is about $22,000 in
00:07:08.480 | 2020. So that means your car might have appreciated by $4,400 to $8,800. That's pretty significant.
00:07:18.080 | So it's something to think about in terms of a bullish data point. Let's say you buy a new
00:07:22.320 | $40,000 vehicle and put down $5,000. You borrow $35,000 over a 60-month period at a 3% interest
00:07:29.040 | rate. After taxes and fees, your monthly auto loan bill is $629. Now, let's say the interest
00:07:36.480 | rate increased by 1%. That monthly payment goes up to $652.51. Not that big of a deal. All the same,
00:07:45.840 | try not to get an auto loan to buy a depreciating asset. Let's move on to how Fed rate hikes affect
00:07:51.600 | mortgages. One of the biggest misunderstandings in personal finance is that the Federal Reserve
00:07:56.720 | controls mortgage rates. This is simply not true, folks. The Fed has some influence over mortgage
00:08:02.720 | rates, but not nearly as much as the bond market does. I would say the bond market has an 80%
00:08:09.040 | influence on mortgage rates, and the Federal Reserve has a 20% influence on mortgage rates,
00:08:14.160 | because the Fed funds rate is the very short end of the yield curve. It's the overnight lending
00:08:20.640 | rate amongst banks, whereas mortgage rates are generally fixed for 5, 7, 10 years and 30 years,
00:08:28.560 | 30-year fixed rate. The bond market with the 10-year bond yield is much closer in duration
00:08:34.240 | to mortgage rate durations, which is why the bond market has greater impact on where mortgage rates
00:08:40.240 | are going. There is a long-term battle between the Federal Reserve and the bond market. The Federal
00:08:46.320 | Reserve is usually a little bit too slow or a little bit too fast, whereas the bond market is
00:08:52.000 | the bond market. It is the culmination of billions and billions and billions of dollars from investors
00:08:58.320 | and sovereign wealth funds who invest their money and act according to their beliefs. And the bond
00:09:04.080 | market has been a much better indicator of booms and busts. If you look back at history, the 10-year
00:09:12.080 | bond yield, which is a better indicator for mortgage rates, has moved by less than half as
00:09:18.560 | much as the magnitude of the Fed funds rate increases over a cycle. So in other words,
00:09:23.840 | if the Fed funds rate has increased by 1%, the 10-year bond yield has increased by less than
00:09:30.080 | a half percent, which means mortgage rates have increased by less than a half percent.
00:09:35.360 | So let's do something really awesome, an analysis of where mortgage rates will be in one or two
00:09:42.640 | years if the Fed funds rate does indeed increase to 1.75 to 2% by the end of 2022, and to 2.5% to
00:09:52.160 | 2.75% by the end of 2023. So given that the 10-year bond yield increases by less than half the
00:10:00.320 | magnitude increase of the Fed funds rate, one can assume that by the end of 2022, the average 30-year
00:10:07.920 | fixed rate mortgage will increase by 0.75% to 1% to 4.75% to 5%. This is by the end of 2022 again.
00:10:17.440 | And if we look to 2023, if the Fed is serious about hiking another three times, well, we can
00:10:24.320 | assume that the average 30-year fixed mortgage rate will increase to 5% to 5.375% in two years.
00:10:32.480 | So now that you know how mortgage rates will be affected by the Fed funds rate hikes,
00:10:38.160 | how do you feel? Do you feel those mortgage rates are very high? It's hard to say because again,
00:10:44.240 | if inflation is, let's say, over 5%, then negative real mortgage rates will continue. And that's
00:10:50.960 | great for borrowers. You still want to rationally borrow more. And if we have another two years of
00:10:56.480 | strong wage growth and corporate earnings growth and balance sheet growth, well, paying 4.75% to
00:11:04.080 | 5.375% is not that much for the average 30-year fixed rate mortgage.
00:11:09.760 | Think about gas prices today. So the average price per gallon in America is about $4,
00:11:15.040 | which is back to where it was in 2008 and similar in 2011. However, most of us, maybe all of us,
00:11:22.960 | are much wealthier today than back in 2008 and 2011. Therefore, we should be able to easily or
00:11:30.160 | more easily withstand these prices. So obviously, the folks who were not investing in saving since
00:11:36.400 | then are going to have a harder time. But we've got to look at the country as an aggregate as
00:11:41.520 | we're thinking about economic output. So bottom line, I wouldn't be too stressed about rising
00:11:47.600 | borrowing costs with the Fed hiking rates. So now let's move forward and see how the stock market
00:11:52.800 | has historically performed during a Fed rate hike cycle. And it's pretty good news, folks.
00:11:58.320 | The S&P 500 is positive 50%, 75%, and 100% of the time, three months, six months, and 12 months
00:12:07.440 | after the first rate hike. So based on historical performance, we should stay invested for as long
00:12:13.600 | as possible. Tell yourself to hold on for at least a year. Instead of selling stocks during a
00:12:18.560 | correction or bear market, you probably want to be accumulating more, especially if you have a
00:12:23.360 | longer time frame. The only time we should really be selling stocks is if we realize our risk
00:12:28.960 | exposure is too great. And the only way of really knowing whether your risk exposure is too great
00:12:34.160 | is to lose money and then analyze how you feel. And of course, the other time to sell stocks is
00:12:40.560 | decumulation phase, right? You're retired, you need to sell off or withdraw to fund your lifestyle.
00:12:47.200 | Now let's talk about how S&P 500 sectors perform in Fed rate hike cycles. The baseline is the S&P
00:12:54.240 | 500 performance, which has an annualized return of 7.8% during Fed rate hike cycles. Now let's look
00:13:00.880 | at the sectors, the five sectors that perform even better than the S&P 500. Number one is technology
00:13:06.800 | at 20.6%. That seems like a surprise, but that's the fact. Real estate, 12%. Maybe another surprise.
00:13:15.760 | Three, energy, 11.9%. Less of a surprise, especially with higher energy prices. Healthcare,
00:13:22.320 | 9.7%. Not a surprise because healthcare costs are just crazy out of control in America. And if you
00:13:28.720 | look at the healthcare stocks, they're just juggernauts. And so if you can't beat them,
00:13:32.960 | you might as well join them and invest in them. Next, we have utilities up 8.3%. I thought this
00:13:38.880 | was interesting. And then S&P 500 at 7.8%. Now the underperformers to the S&P 500, these sectors are
00:13:46.400 | still going up. Industrials, 7.7%. Then we have financials, annualized growth, 5.3%. This is
00:13:54.400 | interesting because I thought it would be a little bit higher because in a rising interest rate
00:13:58.560 | environment, financials generally have increasing net interest margins. It borrows on the short end,
00:14:04.880 | lends on the long end, the spreads increase. So that was kind of surprising. Financials, 5.3%,
00:14:10.640 | and a little disappointing. And then we have discretionary up 2.4%. Materials, 2.1%. Staples,
00:14:18.400 | 1.9%. And communication services, only 0.7%. So let's talk about why tech stocks have outperformed
00:14:27.920 | in a rising interest rate environment. 20%, that's a lot, right? But historically, you know
00:14:34.000 | that tech stocks are growth stocks, and they generally innovate, cut costs, and do very well
00:14:40.160 | during bull markets. Initially, you would think that higher interest rates would hurt the technology
00:14:45.840 | sector because the tech sector is usually more sensitive to rising rates, given a higher discount
00:14:52.000 | rate, higher interest rate, reduces the present value of its expected cash flow when conducting a
00:14:58.320 | DCF analysis. So in other words, if you think there's high inflation, well, it reduces the
00:15:04.880 | buying power of your dollar. Technology stocks tend to trade more on future expected earnings
00:15:10.320 | as well, right? They're talking, you know, earnings five years in the future, 10 years in the future,
00:15:15.280 | and then you extrapolate. And so the longer in the future earnings are going to come in,
00:15:20.400 | the less valuable they are today, if you discount it with a higher interest rate.
00:15:25.920 | I hope that makes sense. However, the empirical evidence shows otherwise. One reason why the S&P
00:15:32.960 | 500 tech earnings are less sensitive to changes in interest rates than other S&P 500 sector earnings
00:15:38.960 | is because tech companies usually have less debt financing than non-tech sectors. Just think about
00:15:44.560 | Apple, for example. You know, at one point, maybe they have $100 billion on their balance sheet.
00:15:50.320 | So if interest rates go up, they actually earn higher interest income. And since they have very
00:15:56.880 | little debt financing, their debt financing costs don't go up as much as other sectors.
00:16:03.680 | Another reason the technology sector tends to perform well during a Fed rate hike cycle
00:16:07.760 | is that tech stocks do not sell big ticket items their customers have to finance.
00:16:12.160 | For example, most people can buy Apple AirPods. They can pay cash and put it on their credit card
00:16:16.800 | and pay it off after one billing cycle. The same goes for subscribing to cloud software by Microsoft.
00:16:23.040 | Right. However, most people are not paying cash for a $40,000 brand new car. And if you look at
00:16:29.600 | the post, there's this great chart that shows how valuations for the S&P 500 technology sector
00:16:34.800 | sometimes increases as the 10-year Treasury yield increases. So the empirical evidence
00:16:41.760 | is quite interesting. And so the logic you think in your head sometimes might not be the reality.
00:16:47.840 | Given the data, I'm going to hold on to my beaten down tech stocks. They've been really
00:16:52.720 | beaten down since November 2021. But I've held on to these names like Google, Amazon, NVIDIA,
00:16:58.800 | and Apple for years now. And I'm going to be buying more. And I'm also looking at bombed
00:17:03.760 | out names like DocuSign and Affirm, which look interesting. However, this is not investment
00:17:09.520 | advice. So please do your own due diligence. Real estate. Real estate is my favorite asset class to
00:17:15.760 | build wealth. And real estate is number two on the sector performing list at 12% annualized returns.
00:17:21.360 | And some of you might be surprised. How can real estate outperform when mortgage rates could be
00:17:27.200 | going up? Well, the answer is that real estate benefits more from a stronger economy and rising
00:17:32.720 | rents than it gets hurt by rising mortgage rates. Further, given real estate is a key component of
00:17:38.400 | inflation, real estate tends to do very well in an inflationary environment. It rides the wave.
00:17:44.960 | The Federal Reserve tends to hike the Fed funds rate in a strong economic environment,
00:17:49.920 | not a weak one. Therefore, real estate tends to outperform when interest rates are rising because
00:17:55.040 | the strength of the labor market, corporate earnings, and wage growth overwhelms rising
00:18:01.200 | borrowing costs. But again, here's the point worth repeating. Mortgage rates don't necessarily
00:18:07.440 | rise as much as the Fed hikes its Fed funds rate. Take a look at the chart in the post that
00:18:13.200 | highlights the 30-year fixed rate mortgage average versus the effective federal funds rate. And you
00:18:19.360 | will see how the average 30-year fixed rate mortgage does not increase by a similar magnitude
00:18:25.440 | than the Fed funds rate. It's less than half. And I suspect things will be no different during this
00:18:32.320 | interest rate hike cycle. Instead, you're going to see a flattening of the yield curve. And given
00:18:38.400 | the Fed has telegraphed 12 to 24 months of hikes, it has time. It has time to change course, which
00:18:43.840 | is why I'm not so sure that it will really increase by how much it says it'll increase.
00:18:50.160 | So what am I doing? I am buying single-family rentals and multifamily properties. I think
00:18:55.600 | that makes sense. I'm also investing in built-to-rent funds and other private real estate
00:19:00.320 | funds that specialize in rental properties. Fundrise, for example, specializes in single-family
00:19:06.320 | and multifamily rentals across the heartland. They call it the Sunbelt. And I think they're
00:19:10.880 | in a good position over the next several years. So if you're a fan of technology and real estate
00:19:16.400 | like I am, then the data says this Fed rate hike cycle is generally positive. Of course,
00:19:23.040 | there's going to be a lot more volatility to come. You got to expect the unexpected.
00:19:28.240 | But I really like how the Fed telegraphed their rates and was more aggressive than the market
00:19:34.080 | thought, because that gives it room to cut back if necessary. It's worth staying on our toes,
00:19:40.720 | folks. The speed of change is increasing in the financial markets. Just look at oil prices. It
00:19:46.240 | surged by 30% in one, two weeks. Then it collapsed by 30% in one or two weeks. We got to stay on our
00:19:53.040 | toes. And I'll do my best to keep you all informed over the next coming months. Thank you and take
00:19:58.560 | care. If you enjoyed this podcast, I'd love a positive five-star review. It keeps me going.