How Interest Rates Affect Your Investments

The Federal Reserve has approved the first interest rate raise in more than three years in March 2022, with more expected in the coming months. Officials indicated an aggressive path ahead, with rate rises at least 5 2022 and 2023.

Have you wondered what exactly is an interest rate?

An interest rate is the amount of money you have to pay if you borrow it from someone (a bank, a credit union, the local pawnbroker). If you deposit your cash with an institution or a person, they have to pay you interest because they use your money.  Almost everyone, if not everyone, in the US owes or is owed something.

Who is responsible for setting the interest rate?

Each country has a central bank that regulates the sector and determines the level of interest rates.

The Impacts Of Interest Rates Changes

In the US, this is the Federal Reserve, in the eurozone – the European Central Bank, in the UK – Bank of England. Changing the value of interest rates is part of the monetary tools a central bank can use when trying to regulate the supply and demand.

So, rates are just one of the instruments that can affect the economy of a country.

Let's see how interest rates affect different markets and segments of the economy:

1. Inflation Expectations

The current inflation pace in the US is the strongest in the last 2 decades.

There is a strong bond between interest rates and inflation. There is a simple and general rule: when rates go down, inflation goes up. If a central bank decides to increase rates, then inflation is expected to go down.

Why?

When rates are low, people tend to take out loans (Mortgage, auto loan or FHA loan) and generally – borrow more. This, on the other hand, makes them spend more, which leads to higher prices. Usually, economies grow in such conditions.

In contrast, increasing interest rates lead to lower consumer spending. More people put money in bank deposits because of the higher rates. Consequently, inflation decreases due to slack demand.

2. Bond Market

The relationship between bonds and interest rates is really complicated.

Let’s look at it in detail:

The basic rule is that when interest rates rise, bond prices decrease. In financial terms, this is the so-called inverse correlation. This is also known as interest rate risk. Here, we need to consider one thing to explain this puzzle – a bond's yield and maturity. This is the profit an investor can make for a specific period of time (let's say 10 years).
For example, a treasury bond offers a 2% coupon rate and market interest rates stand at 2%. Next year, however, rates drop to 1% and newly issued bonds have 1% coupon rate. The old ones, which you own, will still carry the 2% rate. That's why, if you sell these 2% bonds you'll get a higher price for them (because they give a higher coupon rate than the new ones.)

However, for the people who purchase these bonds, the yield to maturity will be lower than a year ago. This is why bond prices usually rise when interest rates are reduced.

Savings bonds are one of the safest investments, but over time investors have become a little more confident about taking on riskier investments, as you can see from this chart using FED Survey of Consumer Finances data

3. Stock Market

Stock markets are seriously affected by changes in interest rates, and the correlation is not as obvious as with bond markets. It's more indirect.

Just like bonds, when rates are higher, stock markets tend to slow down.

If the Fed, for instance, increases interest rates, it means that banks will borrow money from it at a higher price. Consequently, banks increase rates on their loans and lend money at a higher price.

Usually, people and businesses alike refrain from borrowing when the costs are higher. In these conditions, companies cannot normally expand and grow, sometimes they even shrink and cut back on expenditure. The price of their shares, of course, declines as a consequence.

But there’s one small catch:

In theory, this is how it goes. But in the US, following three interest rate hikes in a row, stock markets are on the rise and there are no signs of a bearish market.

Why? Well, for now – markets take the Fed's decisions as an indicator that the economy is strong. But let's wait…things can change quickly.