Recently, you may have seen that inflation is the highest it’s been in a long time. And you may have seen that interest rates are on the rise as a result. In a previous blog article, we discussed rising inflation and what it means for your investments. So now, it only makes sense to zoom in on rising interest rates.
We can’t talk about interest rates without mentioning inflation. Simply put, inflation is the increase in prices over time. Right now, we are experiencing inflationary times. In the euro area, inflation is expected to be 7.5% in March, the highest level since data collection started in 1997. For reference, central banks around the world, including the European Central Bank (ECB) in Europe, the Federal Reserve System (Fed) in the US and the Bank of England (BoE) in the UK, have a target of keeping inflation around 2%.
Inflation is high right now for several reasons. One reason is the supply chain disruptions from strong demand for goods following the economy reopening in 2021. On top of that, oil and gas have become more expensive. And when energy prices increase, so do the prices of goods and services across many sectors. According to the ECB, increased energy prices accounted for over half of inflation in January, and the war in Ukraine is also putting a strain on energy prices.
During the corona crisis, many central banks decreased interest rates to help the economy. But as the economy has recovered and inflation has soared, some central banks have begun raising rates. The Fed and the BoE both raised interest rates in March and indicated that there will be further hikes this year.
The ECB has not raised interest rates since 2011 but said that it will wait at least until the last months of the year to do so.
What even are interest rates?
In short, an interest rate is an amount it costs to borrow money. The amount charged is a percentage of the total amount borrowed, meaning the higher the interest rate is, the more you will pay for borrowing money. On the flip side, if you are saving money, the interest rate tells you how much you will receive as a percentage of your savings.
When you hear ‘interest rate’ in the news, it is likely in reference to the rate at which banks can borrow money from central banks. In Europe, this is the European Central Bank (ECB) rate , and in the UK, it is the Bank Rate. But there are a lot of other kinds of interest rates. For example, the Euribor (Euro Interbank Offered Rate) is the average interest rate a large selection of European banks borrows funds from one another, which have five maturities, ranging from one week to 12 months. There are also average overnight rates for which banks lend to one another. In Europe, this rate is called Eonia (Euro Overnight Index Average), and in the UK, it is Libor (London Interbank Offered Rate).
Why do central banks raise interest rates?
Central banks use interest rates as a part of their monetary policy, and one of the main reasons central banks increase interest rates is to combat inflation. Inflation and interest tend to move in the same direction, so when inflation is increasing, so do interest rates and vice versa. Central banks do not have control over inflation, but lowering or increasing rates can indirectly influence inflation.
Lowering interest rates
When central banks lower interest rates, they aim to stimulate the economy. When the costs of borrowing are low, people and businesses tend to borrow and spend more and are less likely to put their money in a savings account. In turn, demand rises, and so do prices, and therefore inflation increases.
Increasing interest rates
When central banks increase interest rates, they aim to slow down the economy. When it costs more to borrow money, people spend less, and therefore demand falls. As a result, prices rise less sharply, and inflation lessens.
How do interest rates impact the markets?
Although interest rates are rising, that doesn’t mean you should change your investment plan. It’s important to think of the long term and keep a well-diversified portfolio. But it is always good to be prepared and know some potential impacts of rising interest rates on the financial markets.
There is not a clear relationship between interest rates and stock prices. However, rising interest rates may impact some stocks more than others. When interest rates rise and companies borrow less money, they may not be growing their businesses as much as before when interest rates were lower, which may lower profitability. When investors expect lower future returns, this may cause them to sell their shares of the company, resulting in lower stock prices.
Some sectors may perform better than others when interest rates rise. For example, financial stocks, such as banks, tend to perform better when interest rates rise because they get more money from lending money. Keep in mind that the performance of companies within the same sector can drastically vary.
In general, bond prices and interest rates move in opposite directions. Bonds typically receive coupon payments that reflect the interest rate. For example, say you buy a government bond for €1,000 that matures in five years and pays a coupon of 3%. So, for five years, you will receive €30 annually in coupon payments and then the €1,000 back at maturity. However, let’s say that interest rates will be cut to 2% six months from now. In this case, the bond paying 3% annually is more attractive than the new 2% bonds. Therefore, investors may be willing to pay more than the face value of €1,000 for the 3% bond to get a better interest rate, and the bond will trade at a premium.
On the other hand, if the interest rate increases, the bond will trade at a discount. Using the same example, you bought a government bond for €1,000 that matures in five years and pays a coupon of 3%. But six months from now, the interest rate will increase to 4%. In this case, the older 3% bonds become less valuable because the new 4% bonds have a higher coupon.
Some bonds are less sensitive to interest rates depending on the type of bond and the issuer. For example, government bonds tend to be more sensitive to interest rates than corporate bonds. Bonds with shorter maturities also tend to be less sensitive to interest rates compared to those with longer maturities.
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The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.
Sources: ECB, IMF, Pimco, SEC, Forbes, BoE, Fed, Bloomberg, Reuters, Investopedia