In the recent past, the US Fed has embarked on a significant interest rate hike cycle, which is among the most substantial we’ve witnessed in the past 35 years. While this development has raised eyebrows, the Fed has also made it clear that interest rates will remain elevated for an extended period.

In this blog post, we’ll explore how interest rates affect various asset classes.

Interest Rates and the Economy

Interest rates have a direct and palpable impact on the economy. When interest rates rise, the cost of borrowing also goes up. This results in a decline in economic activity and reduced consumer expenditure.

Conversely, when interest rates drop, the cost of capital decreases, leading to an uptick in economic activity and increased consumer spending.

Equities: A Negative Correlation

Equity valuations are directly influenced by interest rate movements. They are often determined by discounting the future cash flows and profitability of companies. When interest rates rise, the value of future profits decreases, which is why rising interest rates generally have a negative effect on equity valuations.

However, it’s crucial to note that while there is a negative correlation, other factors also play a significant role in equity valuation and performance.

Bonds: The Inverse Relationship

Bonds and interest rates have an inverse relationship. When interest rates go up, bond prices fall, resulting in negative returns for bondholders. In an environment of rising interest rates, it may be prudent to consider shifting investments towards short-duration bonds.

Conversely, during a period of falling interest rates, long-duration bonds may become more attractive.

Real Estate: Borrowing and Development

Real estate is deeply affected by interest rates. Most investors and developers rely on borrowing from financial institutions to fund real estate ventures. Higher interest rates negatively impact both the demand and supply sides of the real estate market.

During the pandemic, for instance, interest rates hit record lows, leading to a surge in demand for real estate. This led to a decrease in real estate inventory, prompting developers to launch new projects to meet the heightened demand spurt.

Gold: The Relationship with Borrowing Costs

Gold exhibits a negative correlation with interest rates. When interest rates rise, the cost of borrowing increases, leading to lesser investments in gold.

Conversely, as interest rates decline, the cost of borrowing decreases, leading to increased demand for the precious metal.

Conclusion

Interest rates wield substantial influence over the returns generated by different asset classes. It’s clear that rising interest rates have negative implications for:

• Equity valuations
• Long-duration bonds
• Real estate demand and supply
• Demand for gold

However, it’s essential to remember that while interest rates are a critical factor, they don’t operate in isolation. Other economic and market conditions also play crucial roles in determining the performance of various asset classes.

Therefore, a diversified investment strategy that considers multiple factors is often the most prudent approach.