Investment Guide in the Era of Rate Hikes: Understanding How Interest Rate Fluctuations Affect Your Asset Allocation

Recently, the frequent interest rate hike decisions by central banks around the world have become financial headlines, especially the actions of the Federal Reserve, which directly influence global markets. But what exactly does raising interest rates do? Why can raising rates help curb inflation? As an investor, how should you adjust your asset allocation during this rising interest rate cycle? The answers to these questions are directly related to your investment returns.

The Essence of Rate Hikes: Central Banks’ Monetary Policy Tool

Raising interest rates may seem complex, but fundamentally, it is a decision by the central bank to increase the benchmark rate. Each country implements this differently— the Federal Reserve adjusts the overnight borrowing rate, while Taiwan’s Central Bank adjusts the discount rate—but the goal is the same: to manage the money supply by changing borrowing costs.

When the central bank raises rates, the cost of borrowing for banks increases, and this cost is ultimately passed on to consumers and businesses. Financing becomes more expensive for companies, and consumers’ willingness to buy homes and cars decreases. The overall velocity of money in the economy slows down. This is the starting point of how rate hikes work.

The units used in rate hikes include basis points (bps), half a basis point, and one basis point. One basis point equals 0.01%, and 25 basis points (a “quarter”) represent a 0.25% adjustment. When you hear the Fed “raise by a quarter,” it means increasing the benchmark rate by 0.25%.

Why Raising Rates Can Suppress Inflation: Starting from Demand Cooling

Inflation is essentially a decline in purchasing power. When price increases outpace wage growth, the things you can buy with the same amount of money become fewer. How does raising interest rates address this?

For example, when interest rates rise from 1% to 5%, the annual interest cost on a 1 million yuan loan jumps from 10,000 to 50,000. The high borrowing costs make consumers and businesses more inclined to save rather than spend. When market demand decreases, businesses will lower prices to stimulate sales. Reduced demand and falling prices naturally ease inflationary pressures.

This is the logic behind how rate hikes curb inflation. In 2020, when US inflation surged to a 40-year high, the Fed rapidly raised rates from near 0% to over 5% within a year, using aggressive rate hikes to combat runaway prices.

However, rate hikes are not without costs. When everyone is reluctant to borrow and spend, business sales decline, potentially leading to layoffs. Rising unemployment and slowing economic growth are often side effects of rate hikes. The challenge for central banks is to find a balance between controlling inflation and maintaining employment.

Multiple Impacts of Rate Hikes on Investment Markets

In a rising interest rate environment, capital flows tend to shift noticeably:

Stock Market Under Pressure. Higher rates increase corporate financing costs and debt burdens, directly lowering profit expectations. Historical data shows that during the Fed’s two rate hike cycles in 2007 and 2019, the S&P 500 declined accordingly. Tech stocks and high-growth companies are most affected because they rely heavily on capital to expand.

Bonds Become More Attractive. As rates rise, bond yields increase, offering higher returns for bank deposits or bond purchases. Fixed-income products with relatively low risk become more appealing to investors.

Forex Market Volatility Intensifies. Investors tend to move their funds into currencies with higher interest rates. When the US raises rates more than other countries, the US dollar tends to appreciate against other currencies. For example, in 2022, the USD appreciated significantly against the TWD.

Portfolio Adjustment Strategies During Rate Hikes

In the face of rising interest rates, investors can consider the following allocation strategies:

Contrarian Stock Investments. Warren Buffett has pointed out that buying stocks during rate hikes is often the best decision. The reason is that when rates eventually fall, the stocks purchased now will ride the wave of falling rates and appreciate substantially. Historical data over 20 years confirms this—each time rates are cut, the S&P 500 tends to rally strongly.

Shift to High-Yield Stocks. Compared to overall market volatility, stocks of companies with stable dividends offer more predictable returns. Companies that can consistently pay dividends tend to have stable profitability, making these stocks a defensive choice during rate hikes.

Increase Allocation to USD Assets. When the US raises rates above other central banks, the USD is expected to appreciate further. Investing in USD assets or US stocks can benefit from this trend.

The Real Picture of Global Rate Hike Cycles

Taiwan’s Central Bank cut rates by 1 basis point to 1.125% in 2020 due to the pandemic. As inflationary pressures increased, it entered a rate hike cycle starting in 2022, with a total increase of 2.5 basis points throughout the year. In March 2023, it raised rates by another half a basis point to 1.875%. The continuous rate hikes reflect the central bank’s focus on local inflation.

The Federal Reserve experienced a more aggressive cycle. In March 2020, to respond to pandemic shocks, it cut rates to 0%–0.25% and maintained an ultra-loose policy. But when CPI hit a 40-year high in June 2022, the Fed changed course, beginning large rate hikes. Within a year, it raised rates by nearly 5%, the most direct measure to combat inflation.

The Bank of Japan took a very different approach. Japan has maintained low interest rates for a long time to stimulate the economy. Only at the end of 2022 did it slightly adjust the yield curve for government bonds, signaling a mild shift that is viewed as a de facto rate hike.

Investment Decisions During the Rate Hike Cycle

The core purpose of rate hikes is to manage the money supply, control inflation, and stabilize employment. In the short term, decisions depend on current economic conditions; in the long term, market demand and bond yields fundamentally determine the direction of interest rates.

Investors need not be overly pessimistic about a rising rate environment. Historical experience shows that the most aggressive rate hike periods are often good opportunities to position in quality assets. The key is to understand the economic logic behind rate hikes and adjust your portfolio accordingly. Seeking opportunities across high-yield stocks, bonds, foreign exchange, and other assets is more prudent than passively waiting for rate cuts.