We witnessed the RBA lift the official cash rate for the first time in more than 10 years, increasing the target rate 25 basis points to 0.35%. In the US, the Federal Reserve delivered a double' rate hike, increasing its benchmark rate by 50 basis points, the largest single move in 22 years. And not to be outdone, the Bank of England passed its fourth consecutive rate hike.

Markets responded in a volatile fashion to last week news, so let take a look at some of the key concerns and issues unfolding.

Why are Interest Rates Rising?

There is a key theme at play here, and it centres on inflation, which refers to an increase in prices for goods and services, accompanied by a decrease in the purchasing power of money.

Inflation is a concern for central banks, governments and households around the world. Each of us feels the effects of inflation first-hand, whether it be at the supermarket, petrol station or by changing our behaviour to cut back on certain goods and services.

Inflation has soared right around the world, and while Australia has fared significantly better than other nations thus far - the US and Europe have consistently seen inflation above 7% - the interconnected nature of the global economy ensures Australia is not immune from the same challenge. Local catalysts like floods, labour constraints and stimulus injection have come together with what the RBA describes has largely been global factors to push up prices across the economy.

Central banks have a key tool at their disposal when it comes to combating inflation - raising interest rates, which slows demand growth. Tasked with conducting monetary policy to achieve its goals of price stability, full employment, and the economic prosperity and welfare of the Australian people, the RBA targets an inflation reading of between 2-3%, on average, over time. 

With inflation now well above this - most recently, coming in at 5.1% and expected to increase in the near-term - the RBA has lifted rates, following its counterparts in a number of other countries across the world.

How High Might Interest Rates Rise?

There is no way to be certain what interest rate target' might prove sufficient to drive down inflation. However, it is worth pointing out that interest rates have been sitting at historic rock-bottom levels for the last two years. The emergency-level settings we witnessed, as a measure to address the economic fall-out tied to the pandemic, were always unsustainable in the eyes of many, let alone with an economy that is now showing signs of resilience, especially in the labour market.

Over time, the official cash rate has been drifting lower since the end of the Global Financial Crisis, but for most of the 90s and up until the GFC, it was sitting above 5%. In the early 90s, the rate was touching 17.5%. 

Although there is no indication the RBA will be eyeing anywhere near these high rates - conscious of the significant consequences it could bring to borrowers, and in turn, the economy at large - it has indicated it expects to roll out a series of rate hikes over the coming months.

However, an aggressive tightening in monetary policy can also introduce new risks. Namely, the risk of an economic slowdown or recession. This is why some analysts are predicting that rates could initially spike before potentially coming down again within a year or two if central bank action overshoots and ultimately weighs on the global economy.

As a guide, however, economists from the Big Four banks are tipping the RBA official rate has some room to move in 2022. CBA and NAB are eyeing a rate of 1.35% by the last RBA meet of 2022, Westpac is forecasting 1.75% by the end of the year, and ANZ is predicting 1.5%. 

The broader market has been pricing in an RBA cash rate of 3.5% by late 2023, something that remains to be seen. In the US, the neutral' level for interest rates is typically viewed as 2.5%, something the market expects could happen by the end of 2022.

Australia's long-term interest rates; Source: tradingeconomics.com

How does the Market Typically Respond to a Rate Hike Cycle?

With higher interest rates leading to a wealth of permutations for the economy, the impact on the stock market is not so easy to establish, especially when the two have often shared a disconnect.

US markets responded favourably when Fed Chair Jerome Powell indicated 75 basis point hikes were not on the table. But the following day, a warning from the Bank of England about inflation still being likely to accelerate, and the accompanying risk of a recession, spooked investors.

Historically, rising rates and the performance of the stock market do not necessarily share a precise correlation when rates are very low, even though most investors assume higher rates mean tough times for the market. When interest rates were rising in Australia during the early 2000s, the ASX powered its way towards what was a record high at the time. That rally largely came unstuck due to the GFC and financial contagion from abroad rather than the local rate hike cycle. 

Across the last five rate hike cycles in the US, only one prompted negative returns for the benchmark indexes, booking double-digit, and even one triple-digit return across the other periods.

Generally speaking, rates become a concern for share markets when they increase too quickly', or once they pass neutral' levels and start putting pressure on the economy. Even then, the ASX may take its lead from the US, notwithstanding the higher proportion of mining stocks on the local market that are not as prone as growth-oriented tech stocks with distant future cash flows.

For investors it is arguably more valuable to focus on different sectors in isolation during a rate hike cycle when trying to assess the impact.

Financials, whether it be banks or insurers, tend to benefit from rising interest rates as it helps restore margins, providing lending growth doesn't drop off too dramatically. 

As we've previously detailed, historically there has also tended to be some support for energy and gold stocks during inflationary periods that eventually bring on higher interest rates. 

On the other hand, consumer discretionary names are more vulnerable to a decrease in disposable income as mortgage borrowers face higher repayments. 

Real estate trusts have to contend with the prospect of a decrease in property values, but also face a bigger issue, highly-geared balance sheets that entail higher interest expenses.

Growth stocks, particularly unprofitable early-stage names, or those with distant future cash-flows, sometimes face challenges with respect to uncertainty over their valuations.

Ultimately, every sector is impacted in a different way as interest rates rise. Rather than prescribe an outcome for the whole market that data doesn't necessarily back up, investors would be wise to take note of their exposure to different parts of the economy in their share portfolio.