Interest rates and portfolio returns: how rate changes affect every asset class

Interest rates are the single most pervasive macro factor in investing. When central banks change their benchmark rates, the effect propagates through every asset class: bond prices move mechanically, equity valuations shift through their discount rates, currencies respond to relative yield differentials, and commodity prices adjust through cost-of-carry and currency effects. Understanding how rate changes transmit across a portfolio is essential for any investor managing a multi-asset allocation.

How interest rates work

The policy rate set by a central bank—the Federal Reserve's federal funds rate, the ECB's main refinancing rate, the Bank of England's base rate—is a short-term overnight lending rate. It propagates into longer maturities through the yield curve: markets price longer-term rates based on expectations of where the policy rate will be in future years, plus a term premium for lending for longer. The ten-year government bond yield, which is the benchmark for a wide range of borrowing costs in the economy, reflects the market's expectation of the average short-term rate over the next ten years.

Rate changes by central banks are usually responses to inflation or economic conditions. When inflation rises above target, central banks raise rates to slow credit growth and demand. When the economy weakens, they cut rates to stimulate borrowing and investment. The speed and scale of rate changes vary substantially: the 2022–2023 US rate hiking cycle raised the federal funds rate from near zero to over 5% within eighteen months—one of the fastest cycles in modern history.

Effects on bonds

The relationship between interest rates and bond prices is the most direct and mechanically precise: when rates rise, bond prices fall. A bond pays fixed coupons; if market rates rise above the bond's coupon, the bond must fall in price until its yield to maturity matches the market rate. This inverse relationship is not a market opinion—it is an arithmetic consequence of discounting. For a detailed explanation of the mechanism, see bond pricing explained.

Duration determines the magnitude of the effect. A bond with a ten-year modified duration falls approximately 10% in price if rates rise one percentage point; a bond with two-year duration falls approximately 2%. Long-duration bond funds—including many government bond ETFs—are therefore the most exposed to rate rises. The 2022 rate hiking cycle produced bond drawdowns of 20–30% in long-duration government bond indexes, losses comparable in scale to equity bear markets.

Effects on equities

The relationship between interest rates and equity prices is less mechanical than for bonds but operates through several channels. The most direct is the discount rate: equity prices are theoretically the present value of future earnings. When rates rise, the discount rate applied to those future earnings rises, which reduces their present value. Growth stocks—whose earnings are weighted further into the future—are more sensitive to this discount rate effect than value stocks with near-term earnings, which is why growth and technology sectors tend to underperform most sharply in rate-rising environments.

A second channel is earnings: higher rates increase borrowing costs for companies, which reduces profit margins for debt-heavy businesses. Highly leveraged companies—common in real estate, utilities, and consumer staples—are particularly exposed. A third channel is competition from fixed income: when government bonds yield 5%, the equity risk premium required to justify holding equities rises, putting downward pressure on equity valuations. The evidence across rate hiking cycles is that equities typically struggle in the early phases of a hiking cycle—particularly when rate rises are rapid—but tend to recover once rate expectations stabilise.

Effects on currencies and commodities

Higher domestic interest rates tend to attract capital from abroad, as investors seek the higher return available in that currency. This capital flow puts upward pressure on the currency—an effect documented across most major central bank hiking cycles. When the US Federal Reserve raises rates relative to other central banks, the US dollar typically strengthens, which affects the returns of international equity and commodity positions held by US-based investors.

Commodity prices respond to interest rates through two channels. First, the cost of carry: holding physical commodities requires financing, and higher rates increase that cost, which tends to reduce the futures price of commodities. Second, the US dollar effect: most commodities are priced in US dollars. When rates rise and the dollar strengthens, commodities become more expensive for buyers in other currencies, which can reduce global demand and weigh on prices. Energy and precious metals are most sensitive to these dynamics.

The 2022 illustration

The 2022 rate hiking cycle provided a rare empirical test of what happens when central banks raise rates sharply from near-zero levels in an inflationary environment. The result was a simultaneous fall in both equities and bonds—a so-called inflation shock regime that is distinct from the more typical recession regime, where bond prices rise as equities fall (the negative correlation that underpins 60/40 portfolio construction). The Bloomberg US Aggregate Bond Index fell approximately 13% in 2022; the S&P 500 fell approximately 18%. Investors who relied on bonds as a diversifier against equity risk were disappointed. This experience illustrates that the equity–bond correlation is not constant—it is regime-dependent.

Limitations

The relationship between interest rates and asset prices is not deterministic. The same rate rise can be contractionary (driving equity and commodity prices down) or expansionary (if it signals confidence in economic growth) depending on the context. The timing, speed, and starting level of rates all matter. Furthermore, expected rate changes are already priced into markets before they occur; it is surprise rate changes that drive the sharpest market reactions. Predicting the direction of asset prices from rate changes requires predicting both the rate change and how much of it is already priced in.

Interest rates and portfolios in pfolio

pfolio's multi-asset portfolios hold positions across equities, fixed income, commodities, and currencies, all of which are affected by interest rate changes. The platform's momentum-based asset selection means the portfolio adapts to rate regime shifts as they are reflected in price action, rather than making a fixed bet on the direction of rates. Fixed income assets available in pfolio span a range of durations, allowing investors to adjust their interest rate sensitivity explicitly. The overall interest rate exposure of a portfolio is visible across asset class allocations in the pfolio Insights dashboard.

Related articles

• Bond pricing explained: how interest rates and time affect what a bond is worth
• Bond duration explained: how to measure interest rate sensitivity
• The yield curve: what the shape of interest rates across maturities reveals
• Inflation and portfolio returns: how rising prices erode investment gains and what to do about it