Do you really understand what raising interest rates means? An investment survival guide under central bank rate hikes

In recent months, news about interest rate hikes has been everywhere. The Federal Reserve, Taiwan’s Central Bank, Japan’s Central Bank—central banks around the world are one after another wielding the “double-edged sword” of interest rates. But the question is, do you really understand what a rate hike means? Why is it so important? And how does it affect your wallet?

Simply put, a rate hike means the central bank raising the benchmark interest rate. But the economic logic behind it determines your investment returns, mortgage costs, and even salary increases. This article will delve into the details of what a rate hike entails.

What exactly does a rate hike mean?

Raising and lowering interest rates are the two main tools central banks use to control the money supply. Whenever a central bank adjusts the benchmark rate, it sends a signal: what the economy is about to do.

A rate hike means increasing the interest rate level, while a rate cut means lowering it. It sounds simple, but the implementation is quite complex.

Take the Federal Reserve as an example. They achieve their goals by adjusting the overnight borrowing rate (the federal funds rate). When the Fed decides to hike rates, the cost of borrowing between banks rises, and this cost is ultimately passed on to you and me—mortgage interest, credit card interest, auto loans—all go up.

Taiwan’s Central Bank uses a different approach—its discount rate. Although the direct impact on banks isn’t as intense as the Fed’s, the signal is just as clear: the central bank is tightening monetary policy.

What’s the difference between a rate hike and a rate cut?

The numeric language of rate hikes: basis points, half a notch, one notch

In the investment world, you often hear terms like “a one-notch rate hike” or “half a notch.” Those unfamiliar with these units can get confused.

• Basis points (BP): the smallest unit, 1 basis point = 0.01%, so 50 basis points = 0.5%
• Half a notch: an increase of 12.5 basis points, i.e., 0.125%
• One notch: an increase of 25 basis points, i.e., 0.25%

Last year, the Fed raised rates by 3 notches four times, meaning each time by 0.75%, totaling a 3% increase over four hikes. This magnitude is rare in the past decade.

Why do central banks have to hike rates?

At its core, a rate hike is a fight against inflation.

When prices soar and inflation spirals out of control (like the current situation in the US), central banks have no choice. Raising rates makes borrowing more expensive—if the original loan rate was 1%, after a rate hike it becomes 5%. Who would dare to borrow and spend? As demand drops, businesses have to lower prices to stimulate sales, naturally bringing prices down.

But this approach has costs. Reduced demand means companies need fewer employees, leading to layoffs and rising unemployment. So, a rate hike is a gamble: using economic growth to stabilize prices. That’s why people often say that rate hikes are “killing two birds with one stone”—they curb inflation but can harm the economy.

Conversely, during economic downturns and rising unemployment (like when COVID-19 first hit in 2020), central banks slash rates sharply, even close to zero. Borrowing becomes almost free, encouraging both companies and consumers to spend, which helps the economy recover quickly.

The ripple effects of rate hikes: hitting the economy, stock market, and forex market

Once a rate hike begins, chain reactions quickly follow:

Economic activity freezes: People are reluctant to borrow for homes or cars, companies hesitate to invest or expand, and the entire growth engine slows down. To stimulate demand, businesses are forced to lower prices, leading to slower growth or even recession.

Stock markets take a hit: High-growth companies are hit first. These firms rely on borrowing to expand; when rates rise, financing costs soar, growth stalls, and stock prices can halve. Historical data shows that during US rate hike cycles, tech stocks experience the largest declines.

Bond markets become attractive: Rate hikes mean bond yields rise, prompting investors to shift from stocks to bonds for stability and higher returns.

Forex markets shift: Currencies of rate-hiking countries appreciate. Since the US tends to hike more aggressively than other nations, the dollar strengthens significantly, and USD against TWD, JPY, etc., also gains. This is the most direct international market reflection of a rate hike.

How investors can navigate the rate hike cycle?

A rate hike isn’t the end of the world; in fact, it can be an opportunity for savvy investors.

First tip: Bottom-fishing quality stocks

Here’s an investment paradox: the best time to buy quality stocks is during a rate hike. Why? Because when rate cuts come, these stocks—bought at high interest rates—benefit from abundant liquidity, often soaring more sharply.

Looking at 20-year data: during the 2007 and 2019 rate hike cycles, the S&P 500 faced short-term pressure, but each subsequent rate cut triggered a massive rally. Smart investors position themselves during rate hikes, then harvest gains when rates fall.

Second tip: Lock in high dividend stocks

In a rising rate environment, high-dividend stocks become attractive. Why? Because companies that pay dividends tend to have stable earnings and solid fundamentals; plus, compared to volatile stock prices during rate hikes, dividend income remains steady. Receiving quarterly dividends is like getting warmth during a cold winter of rising rates.

Third tip: Go long on the US dollar

In forex, a rate hike means going long on the currency of the rate-hiking country. When the Fed raises rates more than other countries, the dollar tends to strengthen. When the Fed’s rate hikes are significantly larger than Japan’s or Europe’s, going long on USD often yields good forex gains.

Taiwan’s central bank rate hike journey

2022 was a “rate hike year” for Taiwan. Amid global inflation pressures, Taiwan’s CPI hit a decade high. The central bank was under pressure and had to act.

Throughout the year, Taiwan raised rates by a total of 2.5 notches, from 1.375% to 1.75%. In March 2023, they continued with a half-notch increase to 1.875%. These figures may seem cold, but they directly impact every loan interest.

Initially, it was thought that rate hikes would pause in 2023, but the central bank signaled in March that as long as inflation isn’t under control, rate hikes will continue. This means borrowing costs for home purchases and startups will keep rising.

US rate hike data review

The US’s rate hikes have been “surgical and precise.” From the emergency rate cuts in 2020 (federal funds rate dropping from 1.5-1.75% to 0-0.25%) to the aggressive hikes in 2022 (raising 5% within a year), the speed of change was astonishing.

Why? In 2022, US CPI hit a 40-year high, and runaway inflation left the Fed with no choice. Starting in June, they implemented large increases: three- and four-notch hikes, until easing at year-end.

What’s the cost of this approach? Bank failures, tech stock crashes, real estate freeze. But inflation was indeed brought under control. In the US, a rate hike means: I’d rather see the economy slow down than let inflation spiral out of control.

Japan’s covert rate hike

Japan’s approach is the most clever. While others openly raise rates, Japan’s central bank plays “covert rate hikes.”

At the end of 2022, Japan announced widening the government bond yield band from ±0.25% to ±0.5%—a technical adjustment that subtly signals tightening. This move surprised markets, and the yen immediately appreciated against the dollar.

In Japan, a rate hike means: I won’t raise rates directly, but I’ll make it clear that the era of quantitative easing is ending.