How interest rates influence every investment you make

Featured image
Finimize logo
author image

Powered by Finimize

27 October 2023

Get informed

Sign up for our fortnightly Compass newsletter

Subscribe now

When you invest, your capital is at risk.

Important: This article was originally written by Finimize. Any opinions offered are those of Finimize and not of CMC Invest.

This information is for guidance purposes and may become out of date at any given time. It is not investment advice. Investments can rise and fall in value. CMC Invest won’t make any assessment of whether the investments you choose are appropriate or suitable for you. If you are unsure of the suitability of any investment, investment service or strategy, you should seek independent financial advice. Past performance does not indicate future results. Capital is at risk.

An interesting introduction

Despite the name, most discussions about interest rates can be a tad dull. It’s easy to zone out when people talk about arcane institutions like the Federal Reserve voting on what to do with rates – but that would be a mistake. Interest rates are one of the most fundamental parts of finance and in order to be a good investor – heck, even a mediocre one – you need to understand the effects they have on markets. Keep reading – we’ll pique your interest.

What are interest rates? When you borrow money, you’re almost always charged interest: a fee that compensates the lender for shelling out their cash and running the risk of potentially not getting it back again. Those fees are normally expressed as an annual percentage of the amount borrowed: mortgages carry interest rates, as do credit cards and overdrafts. (Hopefully none of this is news to you!) You might even get paid interest sometimes if you’re the one doing the lending: the paltry return on your cash savings account, for example.

All these interest rates are based on one underlying rate – that set by your country’s central bank. This “base rate” is either the amount that commercial banks are charged to borrow from each other (as in the US, where the Fed sets the “Federal Funds Rate”), or else the amount banks are charged to borrow from the central bank (like in the UK, where the Bank of England sets the “Bank Rate”).

Because financial institutions pay their interest at that rate, the rates they charge you are based upon it – only slightly higher. If the central bank raises the base rate, banks will likely increase their interest rates too – and the same is true when it comes to lowering them. That has a knock-on effect on the entire economy: a rate change can send stocks and bonds flying, change currency values, and even trigger – or avert – a recession.

Interest rates will affect your investments. And depending on the way the wind’s blowing, you might want to shift your portfolio around. In this article, we’ll dive deep into how interest rates move markets and what those movements mean for you. But first – why change interest rates at all?

Why central banks change rates

Why do central banks adjust interest rates? Central banks use interest rates to influence economic growth – either to heat things up or to cool them down.

Low interest rates reduce the cost of borrowing and help to boost growth: when loans are cheaper, businesses are more likely to take them out. And those businesses might then use that cash to expand operations, leading to increased business activity and reduced unemployment – those new cafés aren’t going to run themselves (at least until the robo-revolution comes).

Lower rates also make it cheaper for individuals to spend on credit – so personal consumption (particularly of high-value items like cars and houses) should tick up too. If an economy seems to be faltering, low interest rates can therefore prop it up on two fronts.

So why raise rates? When an economy is growing, high demand for goods and services means companies can raise their prices. But excessive growth can lead to this inflation becoming erratically rapid (possibly thanks to all that coffee). This makes it difficult for households and businesses to save money or plan for the future, which can ultimately lead to a big bust.

In that scenario, a central bank might raise interest rates to try and temper economic growth: higher rates discourage people from spending by making borrowing more expensive. And the resultant lower demand for goods and services should keep a lid on price rises, bringing inflation back under control.

How often are rates changed? It depends. The US’s central bank meets eight times a year to decide whether to raise, lower, or maintain rates. And it has a dual mandate to control both inflation and unemployment: it makes its decisions depending on which seems to be the biggest problem at the time. In financial jargon, when a central bank is cutting interest rates it's said to be “loosening” monetary policy and is “dovish”. When it’s raising rates, it’s “tightening” monetary policy and is “hawkish”.

Adjusting rates can be controversial: it’s not always clear what the right move is. But when rates do move, markets move too. Next, we’ll take an interest in how rates affect stocks and bonds. Grab a cup of something and settle in...

How rates affect markets

How do interest rates affect bonds? If investors think they’ll be paid 5% interest next year but bonds right now only pay 2% interest, they’ll sell bonds today and wait until next year to buy new ones. As a result, bonds that are currently in the market go down in price when interest rates look like they’re going up.

Short-term government bonds are a type of low-risk loan and therefore closely reflect movements in the base rate. When the base rate rises, the price of these existing bonds will fall until the “yield” they offer investors (their set interest payments as a percentage of their price) is similarly high. Government bonds with a longer duration will be less affected, but they’ll still move – particularly if the central bank’s indicated what might happen to rates in future.

Because government bond payments are as close as you can get to a risk-free return (it’s highly unlikely that a developed government will fail to make them), other riskier assets move in concert. No one’s going to take on more risk unless it’s accompanied by higher returns – so higher government interest rates force existing corporate bonds’ prices down until their yields are also high enough.

What about stocks? Interest rates’ relationship with stocks is a little trickier. By and large, low rates are good for businesses – payments on existing debt are lower, and it’s cheaper to take out more debt with which to finance expansion. There are exceptions, of course: low rates aren’t great for banks, which aren’t able to charge as much for mortgages and so on. And if rates are slashed because a central bank is scared of an economic slowdown, investors might get jittery about companies’ prospects (in the aftermath of the last recession, stock markets continued to fall even after rates bottomed out).

And cash? When the base rate moves, the interest rates banks pay out to ordinary savers will often change too. That means an interest rate hike makes saving more attractive and a cut does the opposite. But don’t expect a perfect correlation between the base rate and your bank account – banks would rather pocket some of the extra interest than give it to you.

It's not just stocks and bonds that move when rates do – currency values change too. More on what that means for you next...

How rates affect currencies

How do interest rates affect currencies? In today's global economy, investors can put their money in more or less any country they choose. That means economies are competing with each other when it comes to interest rates.

If the US has interest rates of 1% while the UK’s paying 5%, it doesn't make much sense to invest in US bonds: you could get a much better return in the UK without taking on much more risk, as neither government is likely to default. Smart investors will therefore buy the British pounds necessary to buy British bonds. And that heightened demand for the currency will drive up its relative worth: the pound will increase in value.

But just like with stocks, it gets a bit more complicated. If high interest rates are accompanied by persistently high inflation in a country, investors might be worried about the value of their cash getting eroded over time. And if they therefore choose not to invest in that economy, that would push the value of its currency down.

What do different currency values mean for me? If your country’s currency goes up in value, buying things overseas becomes cheaper – a stronger pound can buy more euro-denominated products, meaning you can splash out on another case of Italian wine. But it’s not all good: it would cost Europeans more euros to buy British stuff, so British exports might decline as Italians shy away from pricier products. Too big an imbalance could see businesses suffer.

So, an economy can also be affected by another’s interest rate decision. And developing economies are particularly vulnerable: because their debt is often denominated in US dollars, a more expensive dollar makes paying that debt back cost more. Those economies will therefore often raise their rates in tandem with the US in order to stabilise their currencies and keep overseas investors from pulling out.

Now that you understand exactly what rates can do to currency prices, it’s time to dive into perhaps the most interesting part of all this: rate debates.

Case study: rate debate

Is it always clear which way to move rates? Not at all! Rate decisions can be extremely controversial – economic experts just love to argue the merits of hiking versus cutting. It can be tricky to get your head around these discussions theoretically, so we’ll look at a case study: the US Federal Reserve’s interest rate decision in June 2019 and the debates around it. For background: interest rates were sitting at 2.25-2.5% after four rate hikes in 2018 (the Fed sets a target range rather than an absolute number to make it easier for it to control rates).

What was the argument for raising rates? US inflation, though not quite at the Fed’s target of 2%, was close enough to raise some hackles. With stock markets near record highs and unemployment extremely low, some investors were concerned about an overheating economy – which raising rates would help to cool.

If a US recession was to hit in the near future – and most forecasts at the time agreed one was due – having the ability to slash high interest rates would be very handy. A dramatic cut in interest rates helped stimulate a flailing economy in 2008, for instance. If rates are already low when a recession hits, there won’t be much room to slice them and boost growth…

Why did people disagree? Some people think recessions can be fought without big interest rate cuts – they argue that other tools like government spending can do the job. And, with inflation below the magic number, they argued that a rate hike wasn’t yet necessary.

In fact, many – including the US president – advocated a June rate cut. They pointed to indicators of an economic slowdown and fears that the US-China trade war could hurt growth even more. And they argued that the boost to investment that a rate cut could deliver would help to prolong economic expansion and stave off a recession.

What ended up happening? The Fed, ever the diplomat, decided to keep rates the same. It suggested that a rate cut was on the cards for later in 2019 – although the committee was divided and minds weren’t yet made up.

So, there you have it: you’re now an interest rate expert. And with interest rate changes a possibility at least eight times a year, you’ll have plenty of chances to put your new knowledge to use.

In this article, you’ve learned:

🔹Central banks set “base rates” upon which all other interest rates are based

🔹Banks raise rates to curb inflation – and cut them to stimulate economic growth

🔹Higher rates generally mean price drops for existing bonds and stocks – lower rates are better for both

🔹Higher rates increase local currency values, but this has its downsides

🔹People don’t always agree about which direction to move rates: there’s often a debate over the right course of action.