Hello everybody, it's Sam from Financial Samurai. So the Fed has finally hiked rates on March 16, 2022. This is the first time since December 2018. And in this episode, I want to talk about why Fed rate hikes will have little impact on borrowing costs over the next 12 months, and also how the stock market has performed during previous Fed rate hike cycles.

First of all, I think we can all agree that the Fed is behind the curve a little bit, actually probably a lot given inflation. The last print was at 7.9%. The Federal Reserve's goal is to try to get inflation around 2%, 2 to 2.5%. And the other goal is to try to get the unemployment rate down to about 3.5% to 4%.

That is the employment rate, which indicates full employment, because there's always going to be people unemployed at any given point in time. So yes, the Fed is behind the curve when it comes to hiking rates. And that's understandable. The Fed would rather be a little too slow in hiking rates than a little too fast in order to help our economy survive a pandemic.

Put it another way, which would you rather have? Higher inflation and a stronger labor market, or lower inflation and a weaker labor market? So the former is usually preferred, which is why we are seeing elevated inflation at the moment. The median projection for inflation in 2022 by the Federal Reserve Board of Governors is 4.3%.

Now again, we just had 7.9% print in February. So 4.3%, I don't know, let's see. Inflation really has to drop down in the second half of the year. And for 2023, they're expecting 2.7%. That also seems pretty suspect. 2.7%, that's almost back to the ideal inflation target that the Federal Reserve wants to have, wants to achieve.

So I have my doubts. However, anything can happen over the next 12 to 24 months. The Federal Reserve was more aggressive than expected. They're talking about hiking rates in the six remaining meetings in 2022. And if they hike by 25 basis points, that implies that the Fed funds rate will be in the range of 1.75% to 2% by the end of 2022.

And they also committed to hiking three more times in 2023, which implies the Fed funds rate will be at 2.5% to 2.75% by the end of 2023. Is this likely? It just doesn't seem likely. However, if inflation stays, let's say over 6% in 2022, and over 4% in 2023, the probability is more likely.

So how do we consumers get affected by rising rates? Well, I don't think most Financial Samurai readers and listeners will get significantly impacted at all, because the rate increases are very gradual. A 25 basis point increase is 0.25%. And the Fed is talking about increasing every meeting and every meeting is every one to two months, right?

So the increase is very gradual, and you know it's coming. So if you know it's coming, you can refinance your variable rates to fixed rates if you wish. Or you can pay down more debt more quickly, so you don't have to pay those higher rates. So I will commend the Fed, commend Jerome for telegraphing exactly what they plan to do over the next 12 to 24 months.

This visibility is very important to set expectations for investors and for consumers and borrowers. And better yet, the Fed has been more aggressive than expectations. Before they hiked rates, the fund management community was expecting more like four rate hikes over the next 12 months at 25 basis points each, so 1% versus six rate hikes or 1.5%, right?

So the Fed was more aggressive than expectations, but that sets expectations and that allows the Fed, that enables the Fed to stop, to pause if necessary if things change, because things are always changing. So how will Fed rate hikes affect credit cards? Well, unfortunately, credit cards, the average APR is about 16% to 17%.

And credit cards are variable rates. So when the Fed hikes the Fed funds rate, credit card rates will likely go up in similar fashion. However, let's say you have $10,000 in credit card balance and your interest payment goes up by 0.25%. Well, that's a mere $25 a year, so you're not going to really feel it.

Even a 1% interest rate hike is only an extra $100 a year on a $10,000 balance. And that is if you hold the entire balance all year. So presumably you're going to start being more aggressive in paying down that balance before you have to pay a higher interest rate.

Or what I think you might want to do is look into personal loans. Personal loans, they don't sound very good, but the average personal loan rate is much lower than the average credit card rate. So the average personal loan rate is about 9%. The average credit card rate is about 16.5% right now.

So that six and a half, seven and a half spread is significant to save money over the long term if you're having trouble paying down your credit card debt. Now, the other method I like to paying down credit card debt, well, to at least save on interest, is to just call your credit card company and ask, "Hey, I've never missed a payment over the past 6, 12, 24, 5 years.

Is there any way you can lower my interest rate?" It never hurts to ask, so you might as well ask. In terms of how Fed rate hikes affect auto loans, well, not so much. Not so much because you're probably getting a fixed rate loan on your auto loan. It's usually three years or five years.

So if you've got an auto loan, nothing is going to change. Now, if you want to get an auto loan, which I'm not a proponent of because you're buying a depreciating asset with borrowed money, that's never generally a good idea. But if you insist to do so, your auto loan rate will depend more on your down payment and your credit score.

Yeah, the rate might go up a little bit, but these car companies and dealerships have plenty of ways to make a lot of money off of you in addition to auto loans. This is just a one way to get you to buy the car that you probably shouldn't have paid so much for.

And if you look at used car prices, it's really interesting. The prices are up something like 30% to 40%. So if you leased a car three years ago or two years ago, you're probably well in the money. And the other thing to think about is, a lot of people are talking about how high oil prices may crush the consumer, right?

Well, yeah, high oil prices stink, but it could be temporary. It's probably going to be temporary. But if your used car appreciated by 20% to 40% over the past two to three years, that really, I think, deflects a lot of the pain from paying higher gas prices. The average used car price is about $22,000 in 2020.

So that means your car might have appreciated by $4,400 to $8,800. That's pretty significant. So it's something to think about in terms of a bullish data point. Let's say you buy a new $40,000 vehicle and put down $5,000. You borrow $35,000 over a 60-month period at a 3% interest rate.

After taxes and fees, your monthly auto loan bill is $629. Now, let's say the interest rate increased by 1%. That monthly payment goes up to $652.51. Not that big of a deal. All the same, try not to get an auto loan to buy a depreciating asset. Let's move on to how Fed rate hikes affect mortgages.

One of the biggest misunderstandings in personal finance is that the Federal Reserve controls mortgage rates. This is simply not true, folks. The Fed has some influence over mortgage rates, but not nearly as much as the bond market does. I would say the bond market has an 80% influence on mortgage rates, and the Federal Reserve has a 20% influence on mortgage rates, because the Fed funds rate is the very short end of the yield curve.

It's the overnight lending rate amongst banks, whereas mortgage rates are generally fixed for 5, 7, 10 years and 30 years, 30-year fixed rate. The bond market with the 10-year bond yield is much closer in duration to mortgage rate durations, which is why the bond market has greater impact on where mortgage rates are going.

There is a long-term battle between the Federal Reserve and the bond market. The Federal Reserve is usually a little bit too slow or a little bit too fast, whereas the bond market is the bond market. It is the culmination of billions and billions and billions of dollars from investors and sovereign wealth funds who invest their money and act according to their beliefs.

And the bond market has been a much better indicator of booms and busts. If you look back at history, the 10-year bond yield, which is a better indicator for mortgage rates, has moved by less than half as much as the magnitude of the Fed funds rate increases over a cycle.

So in other words, if the Fed funds rate has increased by 1%, the 10-year bond yield has increased by less than a half percent, which means mortgage rates have increased by less than a half percent. So let's do something really awesome, an analysis of where mortgage rates will be in one or two years if the Fed funds rate does indeed increase to 1.75 to 2% by the end of 2022, and to 2.5% to 2.75% by the end of 2023.

So given that the 10-year bond yield increases by less than half the magnitude increase of the Fed funds rate, one can assume that by the end of 2022, the average 30-year fixed rate mortgage will increase by 0.75% to 1% to 4.75% to 5%. This is by the end of 2022 again.

And if we look to 2023, if the Fed is serious about hiking another three times, well, we can assume that the average 30-year fixed mortgage rate will increase to 5% to 5.375% in two years. So now that you know how mortgage rates will be affected by the Fed funds rate hikes, how do you feel?

Do you feel those mortgage rates are very high? It's hard to say because again, if inflation is, let's say, over 5%, then negative real mortgage rates will continue. And that's great for borrowers. You still want to rationally borrow more. And if we have another two years of strong wage growth and corporate earnings growth and balance sheet growth, well, paying 4.75% to 5.375% is not that much for the average 30-year fixed rate mortgage.

Think about gas prices today. So the average price per gallon in America is about $4, which is back to where it was in 2008 and similar in 2011. However, most of us, maybe all of us, are much wealthier today than back in 2008 and 2011. Therefore, we should be able to easily or more easily withstand these prices.

So obviously, the folks who were not investing in saving since then are going to have a harder time. But we've got to look at the country as an aggregate as we're thinking about economic output. So bottom line, I wouldn't be too stressed about rising borrowing costs with the Fed hiking rates.

So now let's move forward and see how the stock market has historically performed during a Fed rate hike cycle. And it's pretty good news, folks. The S&P 500 is positive 50%, 75%, and 100% of the time, three months, six months, and 12 months after the first rate hike. So based on historical performance, we should stay invested for as long as possible.

Tell yourself to hold on for at least a year. Instead of selling stocks during a correction or bear market, you probably want to be accumulating more, especially if you have a longer time frame. The only time we should really be selling stocks is if we realize our risk exposure is too great.

And the only way of really knowing whether your risk exposure is too great is to lose money and then analyze how you feel. And of course, the other time to sell stocks is decumulation phase, right? You're retired, you need to sell off or withdraw to fund your lifestyle. Now let's talk about how S&P 500 sectors perform in Fed rate hike cycles.

The baseline is the S&P 500 performance, which has an annualized return of 7.8% during Fed rate hike cycles. Now let's look at the sectors, the five sectors that perform even better than the S&P 500. Number one is technology at 20.6%. That seems like a surprise, but that's the fact.

Real estate, 12%. Maybe another surprise. Three, energy, 11.9%. Less of a surprise, especially with higher energy prices. Healthcare, 9.7%. Not a surprise because healthcare costs are just crazy out of control in America. And if you look at the healthcare stocks, they're just juggernauts. And so if you can't beat them, you might as well join them and invest in them.

Next, we have utilities up 8.3%. I thought this was interesting. And then S&P 500 at 7.8%. Now the underperformers to the S&P 500, these sectors are still going up. Industrials, 7.7%. Then we have financials, annualized growth, 5.3%. This is interesting because I thought it would be a little bit higher because in a rising interest rate environment, financials generally have increasing net interest margins.

It borrows on the short end, lends on the long end, the spreads increase. So that was kind of surprising. Financials, 5.3%, and a little disappointing. And then we have discretionary up 2.4%. Materials, 2.1%. Staples, 1.9%. And communication services, only 0.7%. So let's talk about why tech stocks have outperformed in a rising interest rate environment.

20%, that's a lot, right? But historically, you know that tech stocks are growth stocks, and they generally innovate, cut costs, and do very well during bull markets. Initially, you would think that higher interest rates would hurt the technology sector because the tech sector is usually more sensitive to rising rates, given a higher discount rate, higher interest rate, reduces the present value of its expected cash flow when conducting a DCF analysis.

So in other words, if you think there's high inflation, well, it reduces the buying power of your dollar. Technology stocks tend to trade more on future expected earnings as well, right? They're talking, you know, earnings five years in the future, 10 years in the future, and then you extrapolate.

And so the longer in the future earnings are going to come in, the less valuable they are today, if you discount it with a higher interest rate. I hope that makes sense. However, the empirical evidence shows otherwise. One reason why the S&P 500 tech earnings are less sensitive to changes in interest rates than other S&P 500 sector earnings is because tech companies usually have less debt financing than non-tech sectors.

Just think about Apple, for example. You know, at one point, maybe they have $100 billion on their balance sheet. So if interest rates go up, they actually earn higher interest income. And since they have very little debt financing, their debt financing costs don't go up as much as other sectors.

Another reason the technology sector tends to perform well during a Fed rate hike cycle is that tech stocks do not sell big ticket items their customers have to finance. For example, most people can buy Apple AirPods. They can pay cash and put it on their credit card and pay it off after one billing cycle.

The same goes for subscribing to cloud software by Microsoft. Right. However, most people are not paying cash for a $40,000 brand new car. And if you look at the post, there's this great chart that shows how valuations for the S&P 500 technology sector sometimes increases as the 10-year Treasury yield increases.

So the empirical evidence is quite interesting. And so the logic you think in your head sometimes might not be the reality. Given the data, I'm going to hold on to my beaten down tech stocks. They've been really beaten down since November 2021. But I've held on to these names like Google, Amazon, NVIDIA, and Apple for years now.

And I'm going to be buying more. And I'm also looking at bombed out names like DocuSign and Affirm, which look interesting. However, this is not investment advice. So please do your own due diligence. Real estate. Real estate is my favorite asset class to build wealth. And real estate is number two on the sector performing list at 12% annualized returns.

And some of you might be surprised. How can real estate outperform when mortgage rates could be going up? Well, the answer is that real estate benefits more from a stronger economy and rising rents than it gets hurt by rising mortgage rates. Further, given real estate is a key component of inflation, real estate tends to do very well in an inflationary environment.

It rides the wave. The Federal Reserve tends to hike the Fed funds rate in a strong economic environment, not a weak one. Therefore, real estate tends to outperform when interest rates are rising because the strength of the labor market, corporate earnings, and wage growth overwhelms rising borrowing costs. But again, here's the point worth repeating.

Mortgage rates don't necessarily rise as much as the Fed hikes its Fed funds rate. Take a look at the chart in the post that highlights the 30-year fixed rate mortgage average versus the effective federal funds rate. And you will see how the average 30-year fixed rate mortgage does not increase by a similar magnitude than the Fed funds rate.

It's less than half. And I suspect things will be no different during this interest rate hike cycle. Instead, you're going to see a flattening of the yield curve. And given the Fed has telegraphed 12 to 24 months of hikes, it has time. It has time to change course, which is why I'm not so sure that it will really increase by how much it says it'll increase.

So what am I doing? I am buying single-family rentals and multifamily properties. I think that makes sense. I'm also investing in built-to-rent funds and other private real estate funds that specialize in rental properties. Fundrise, for example, specializes in single-family and multifamily rentals across the heartland. They call it the Sunbelt.

And I think they're in a good position over the next several years. So if you're a fan of technology and real estate like I am, then the data says this Fed rate hike cycle is generally positive. Of course, there's going to be a lot more volatility to come. You got to expect the unexpected.

But I really like how the Fed telegraphed their rates and was more aggressive than the market thought, because that gives it room to cut back if necessary. It's worth staying on our toes, folks. The speed of change is increasing in the financial markets. Just look at oil prices. It surged by 30% in one, two weeks.

Then it collapsed by 30% in one or two weeks. We got to stay on our toes. And I'll do my best to keep you all informed over the next coming months. Thank you and take care. If you enjoyed this podcast, I'd love a positive five-star review. It keeps me going.