Interest rates are something that all investors should learn about and pay attention to – they not only impact your everyday life, but importantly, the stock markets, foreign exchange rates and other asset prices.
Interest is essentially the price you pay for using someone else’s money. As a home owner, you may use the bank’s money to buy your home through a mortgage, which comes at a cost. Similarly, credit cards come with interest rates attached to them.
But the interest rates that investors need to understand are Central Bank rates – for example, the Federal Reserve in the US and the European Central Bank. These rates are the prices that banks are charged for borrowing money.
Reasons on why central banks change interest rates
Interest rates are used by central banks to control and limit levels of inflation, the rate at which the prices of goods and services increases. Inflation is caused by a surplus of demand and a relatively weak supply, resulting in prices increasing, and so too the cost of living.So, to keep the economy running smoothly, central banks try to regulate the levels of inflation. And because interest rates influence the amount of money available for purchasing goods, they have the power to affect levels of inflation.
When a central bank increases its interest rates, the stock market isn’t directly affected, but it becomes more expensive for banks to borrow money from the Central Banks. This results in a domino effect, where consumers, businesses and investors are affected.
What does Increased interest rates mean:
Company share prices may decrease
A company’s share price will fluctuate based on the expectations and perceptions that investors have towards a business at different times. If a business is expected to reduce its spending on growth, or it isn’t profiting as much due to higher borrowing costs or a lower income from consumers, the estimated value of that company’s future capital will decrease. This in turn has the potential to lower the price of the company’s shares.
Indexes may fall in value
Share prices have the ability to impact an index’s value: If enough companies listed on an index experience declines in their share prices, that index’s value will fall. This is clearly demonstrated in oil and mining stocks, which have significant influence on changing the value of the FTSE 100.
But the majority of investors don’t want to see falling markets and share prices. They want to see their invested money gain value, which comes alongside share price appreciation, dividends or both…
Bonds become more attractive
When companies have lower growth and cash flow projections, investors are less likely to gain as much profit from owning those their shares – so holding onto or buying into those shares becomes less appealing.
By comparison, treasury bonds, which offer a predictable return at a low risk, are generally viewed as safe investments and often experience a corresponding increase when interest rates rise. In addition, bonds become more profitable to investors as the risk-free rate of return increases.
In principle, when trading shares, a rational investor would want to invest in shares that have the potential for earning more profit than would be earned from investing in bonds (for the fact that the investor would be taking on additional risk by investing in shares). Because of this, in times of higher interest rates and market uncertainty, shareholders may see stock ownership as too risky, and may turn to bonds as a result.
On the other hand, high performing companies with good track records of healthy balance sheets, high revenues, growth and low volatility, may stand to benefit from increasing interest rates.
How to profit from rising interest rates
When changes in interest rates do come by, by understanding how various industries are likely to be affected, you can take advantage of valuable and profitable opportunities – because there are many avenues that investors can go down to profit from rising interest rates.For example, higher interest rates can increase the strength of the home country’s currency – although, it’s essential to be aware of the other features that are at play – a country’s political and economic stability as well as the demand for its goods and services all contribute towards its currency’s strength.
Rising rates can also be positive for the real estate sector and companies that consume raw materials.
In summary, interest rates have wide and diverse effects on the economy and the financial markets. When people spend more, the economy grows, which naturally brings about inflation. Raising interest rates has the effect of discouraging borrowing and encouraging saving. This in turn typically reduces the amount of money in circulation, helping to keep inflation levels low.
As borrowing becomes more expensive, business expenses can increase, resulting in reduced revenues for those with debt to pay. Rising interest rates can also make the stock market a slightly less appealing place to invest, although there are many alternative ways in which to profit from or to hedge against rising interest rates.
However, it’s important to understand that interest rates are only one of many factors that can affect share prices and market trends, so one can never be certain that an increase in interest rates will indeed have a detrimental impact on the markets.
Banks increase rates for borrowing
When interest rates are hiked, banks implement increases to credit card and mortgage interest rates. This makes bills become more expensive to pay, leaving people with less disposable income. Consumers spend less as a result, which can negatively affect business revenues and profits.It also generally means retail banks make more net interest income, the key revenue metric.
Business running costs increase
To run and grow their operations, companies borrow money from banks, and when loans demand higher interest rates, the cost of a company’s capital increases. Higher interest rates cut into a company’s profits, which means that companies need to work harder to generate higher revenue.Because of this, businesses may reduce the amount of money that they borrow, or spend less in order to cut losses. Less business spending can slow business growth, resulting in decreases in profits.
And if profits are lower, combined with lower consumer demand (see point one), high interest rates can have the effect of reducing the value of a company’s shares.
Company share prices may decrease
A company’s share price will fluctuate based on the expectations and perceptions that investors have towards a business at different times. If a business is expected to reduce its spending on growth, or it isn’t profiting as much due to higher borrowing costs or a lower income from consumers, the estimated value of that company’s future capital will decrease. This in turn has the potential to lower the price of the company’s shares.
Indexes may fall in value
Share prices have the ability to impact an index’s value: If enough companies listed on an index experience declines in their share prices, that index’s value will fall. This is clearly demonstrated in oil and mining stocks, which have significant influence on changing the value of the FTSE 100.
But the majority of investors don’t want to see falling markets and share prices. They want to see their invested money gain value, which comes alongside share price appreciation, dividends or both…
Bonds become more attractive
When companies have lower growth and cash flow projections, investors are less likely to gain as much profit from owning those their shares – so holding onto or buying into those shares becomes less appealing.
By comparison, treasury bonds, which offer a predictable return at a low risk, are generally viewed as safe investments and often experience a corresponding increase when interest rates rise. In addition, bonds become more profitable to investors as the risk-free rate of return increases.
In principle, when trading shares, a rational investor would want to invest in shares that have the potential for earning more profit than would be earned from investing in bonds (for the fact that the investor would be taking on additional risk by investing in shares). Because of this, in times of higher interest rates and market uncertainty, shareholders may see stock ownership as too risky, and may turn to bonds as a result.
On the other hand, high performing companies with good track records of healthy balance sheets, high revenues, growth and low volatility, may stand to benefit from increasing interest rates.
How to profit from rising interest rates
When changes in interest rates do come by, by understanding how various industries are likely to be affected, you can take advantage of valuable and profitable opportunities – because there are many avenues that investors can go down to profit from rising interest rates.For example, higher interest rates can increase the strength of the home country’s currency – although, it’s essential to be aware of the other features that are at play – a country’s political and economic stability as well as the demand for its goods and services all contribute towards its currency’s strength.
Rising rates can also be positive for the real estate sector and companies that consume raw materials.
In summary, interest rates have wide and diverse effects on the economy and the financial markets. When people spend more, the economy grows, which naturally brings about inflation. Raising interest rates has the effect of discouraging borrowing and encouraging saving. This in turn typically reduces the amount of money in circulation, helping to keep inflation levels low.
As borrowing becomes more expensive, business expenses can increase, resulting in reduced revenues for those with debt to pay. Rising interest rates can also make the stock market a slightly less appealing place to invest, although there are many alternative ways in which to profit from or to hedge against rising interest rates.
However, it’s important to understand that interest rates are only one of many factors that can affect share prices and market trends, so one can never be certain that an increase in interest rates will indeed have a detrimental impact on the markets.
