How significant is the impact of interest rate hikes? How do central bank rate increases reshape your investment portfolio

Recently, in global economic news, interest rate hikes by central banks have become the most frequently mentioned term. Every decision by the Federal Reserve, the pace of rate hikes by Taiwan’s central bank, all influence the stock market, foreign exchange, and even your bank deposit interest rates. But how exactly do rate hikes affect our lives and investments? This is not just an economic numbers issue; it concerns everyone’s wallet.

What is a rate hike? Why do central banks adjust interest rates?

A rate hike simply means the central bank raising the benchmark interest rate. Cutting rates is the opposite. Both are important tools for central banks to control the flow of money in society.

When the central bank raises rates, the cost of borrowing between banks increases, prompting banks to raise the interest rates they offer to the public. Conversely, when rates are cut, borrowing becomes cheaper, encouraging people to spend and invest more. This simple action can trigger a chain reaction that impacts the entire economy.

Why do rate hikes happen? There are usually two main reasons:

When the economy overheats and inflation gets out of control, prices rise faster than wages, eroding people’s purchasing power. At this point, the central bank raises rates to increase borrowing costs, encouraging reduced consumption, leading to decreased market demand and a natural fall in prices. In 2022, US CPI hit a 40-year high, prompting the Fed to aggressively hike rates, raising interest rates from near 0% to over 4% within a year.

The other scenario is economic recession, where the central bank takes reverse action by significantly lowering rates to stimulate consumption. During the COVID-19 pandemic outbreak in 2020, US unemployment surged, and the Fed immediately lowered rates to 0–0.25%, flooding the market with liquidity and driving a rapid economic recovery.

How much is a one-rate increase? Understanding interest rate units is crucial

The market often hears terms like “a one-rate hike” or “half a point,” but many people are unclear about the specific numbers.

Basis Point (BP) is the smallest unit of interest rate change, with 1 basis point = 0.01%. A half-point hike means an increase of 12.5 basis points, or 0.125%. A one-point hike means an increase of 25 basis points, or 0.25%.

In June, July, September, and November 2022, the Federal Reserve raised rates by 3 points each time, increasing by 0.75% each time. By the end of the year, the US federal funds rate had risen from near 0% to between 4.25% and 4.5%. This aggressive rate hike pace was rare in the past decade, reflecting severe inflationary pressures.

In comparison, Taiwan’s central bank adopted a more moderate pace. In 2022, it cumulatively raised rates by 2.5 points, increasing the discount rate from 1.375% to 1.75%. In 2023, due to CPI exceeding 2% for consecutive months, Taiwan’s central bank further raised rates, pushing the discount rate to 1.875% in March. Japan took a different route—maintaining ultra-low interest rates to stimulate the economy, only making slight adjustments to government bond yields at the end of 2022.

Chain reactions of rate hikes on the economy

The impact of rate hikes extends far beyond your loan interest rates. It reshapes the entire economic ecosystem in various ways.

The most direct impact is on consumption and employment. Higher rates make loans more expensive, increasing costs for home purchases, car loans, and business financing. Consumers cut back on spending, businesses see declining sales, and to avoid losses, they may reduce hiring or lay off staff. Rising unemployment further depresses consumption, creating a vicious cycle. That’s why rate hikes are often accompanied by slower economic growth.

Corporate profitability faces a double hit. On one hand, rising financing costs reduce companies’ willingness to expand investments; on the other hand, sales revenue declines due to weaker consumer spending. High-growth tech companies are hit hardest because they rely heavily on cheap financing to burn cash for growth. This explains why tech stocks have fallen much more than the broader market since 2022.

The bond market benefits from rate hikes. When interest rates rise, newly issued bonds offer higher yields, attracting capital inflows. Existing bond prices fall (since new bonds with higher yields make old bonds cheaper). For investors seeking capital preservation and stable cash flow, bonds become more attractive in a rising rate environment.

Foreign exchange markets also experience volatility. When the US raises rates more than other countries, investors flock to dollar assets for higher returns. The dollar appreciates, and other currencies depreciate. Data from 2022 clearly shows this—USD/TWD exchange rate rose from the low 29s at the start of the year to over 32, an increase of more than 10%.

How to approach stock investments during rate hikes?

Many investors choose to wait or exit the stock market during rate hikes, but investment master Warren Buffett believes this is precisely the wrong timing. His logic is: buying quality stocks in a high-interest environment, once the central bank begins to cut rates, will see their earnings improve, and stock prices will soar on the back of rate cuts.

Historical data supports this view. Over the past 20 years, whenever the Federal Reserve’s rate was high and started to decline, the S&P 500 experienced significant gains. During the 2007–2008 financial crisis, stocks fell sharply, but after the Fed cut rates aggressively, the market rebounded; after the 2019 rate cuts, the market rose steadily in 2020, except for a brief dip early in the pandemic.

However, this does not mean blindly buying stocks during rate hikes. A smarter strategy includes:

1. Shifting to high-dividend stocks. In a rising rate environment, companies that can consistently pay dividends tend to be those with strong cash flows and competitive advantages. Compared to stock price volatility, dividends provide more stability, offering investors regular income. The appeal of such stocks increases during rate hikes.

2. Reducing exposure to high-growth stocks. Tech stocks and emerging industry stocks perform poorly during rate hikes because their growth expectations are most heavily revised downward. Lowering their weight can effectively reduce investment risk during rate hike periods.

3. Focusing on cyclical stocks. Certain sectors benefit from rising rates, such as financial stocks—banks’ net interest margins (the difference between lending and deposit rates) tend to widen with rate hikes, boosting profits.

Bond and forex opportunities amid rate hikes

Rising rates directly push up bond yields, which is positive for new bond investors. If you buy a 3-year bond now, yields might rise from around 2% before the hike to 4% or higher, significantly improving bond attractiveness.

The impact on forex markets is also notable. When US interest rates are much higher than other countries, the dollar appreciates. Investing in dollar assets, holding dollar cash, or US Treasuries can all benefit from the currency’s appreciation driven by rate hikes.

How to guide your investment portfolio during rate hikes?

A rational investment strategy during rising rates should include:

Stock allocation: Reduce exposure to tech and high-growth stocks, increase holdings in financials and high-dividend stocks. Consider dollar-cost averaging into quality companies to smooth purchase prices and prepare for rebounds when rates fall.

Bond allocation: Rising rates mean newly purchased bonds offer higher yields, making fixed income accumulation more attractive. Consider increasing bond holdings, especially short-term bonds, which are less sensitive to interest rate changes.

Cash and forex: Maintain moderate cash reserves to handle emergencies and seize investment opportunities quickly. Hold some dollar assets to benefit from dollar appreciation.

Real estate and other assets: Rate hikes increase mortgage costs, which can dampen the housing market. Buying property just before a rate hike might be more cost-effective; after hikes, it may be better to wait and see. Commodities like gold and oil often underperform during rate hikes and are less suitable for allocation in such periods.

Different rate hike paths in Taiwan, the US, and Japan

The strategies for rate hikes differ significantly among these economies, reflecting their unique economic conditions and policy choices.

The US adopts the most aggressive rate hike path, due to the highest inflation pressures. In just one year, rates increased by over 4%, a scale rarely seen in a decade.

Taiwan’s rate hikes are more moderate, as local inflation, while rising, is less severe than in the US, and export trade considerations also matter. In 2023, the pace of rate increases accelerated somewhat, but the magnitude remains well below that of the US.

Japan takes a different approach—maintaining ultra-low interest rates for a long time, only making symbolic adjustments to government bond yields at the end of 2022, still remaining in an easing policy track.

These different rate hike paces have created varying foreign exchange market performances— the dollar appreciated the most, the yuan depreciated, and the yen experienced cycles of appreciation and depreciation.

Conclusion: Investment wisdom during rate hikes

Rate hikes impact every corner of the economy—your deposit interest, mortgage costs, job stability, and investment returns. But rate hikes are not the end; once they reach a certain level and economic growth slows, central banks will eventually cut rates again.

True investment wisdom lies in: not fearing the volatility brought by rate hikes, but understanding the logic behind their effects and adjusting your portfolio in advance. During rate hike periods, accumulate high-yield bonds and high-dividend stocks, positioning yourself for asset price increases when rates fall. When market sentiment shifts, you’ll already be in the right place.