The Interest Rate Effect: What Is It?
Interest rates affect many things, both for businesses and for us all personally. While they may at first seem disconnected, interest rate changes can actually affect markets too. The overall influence of interest rates is known as the interest rate effect, and it is something that we need to understand as traders and investors.
To better understand why fluctuations in interest rates can affect financial markets, and why we should always take potential changes in interest rates into account when looking at markets, we will look at just how they play a part in different aspects of business, and how we can use that.
Importance of Interest Rates
First, we need to look at just why interest rates are so important, and everything that they influence as a result. In a modern economy, interest rates are a significant factor, affecting growth and investment, ultimately helping shape the overall economic health of the country. There are several areas where the economy can be directly influenced by interest rates such as in trade, housing, and the overall business environment.
1. Trade Deficits
Trade deficits are something the US economy has significant levels of. Here, higher interest rates make government bonds more attractive for foreign investment, bringing capital into the country. However, this has the long-term effect of raising the value of the dollar against other currencies, which in turn enlarges the trade deficit, because exports become more expensive.
2. Housing Market
The housing market is directly linked to interest rates. As interest rates rise, mortgages become less affordable, for individuals looking to buy, this means they can afford to borrow less, but for those already in a home, mortgages that were affordable can become too expensive as mortgage payments increase, leading to many selling up. This increases property supply on the market, deflating values, and this matters for consumer confidence. As investments in property are usually the single largest purchase most people make, falling values means that in real terms, their overall wealth is falling, and they feel less affluent as a result, cutting back on other expenditure.
3. Small and Large Business
Third, it is important to remember that the additional cost of borrowing with higher interest rates also affects businesses, where borrowing for the growth of internal investment becomes more expensive there is a tendency to cut back on investment and as a result, less growth. Less growth for business means less growth for the economy and no added value for the stock.
Interest rates are entwined within the economy itself and the financial well-being of most individuals and companies too, and in addition to these scenarios that affect individuals and businesses, changes in interest rates also affect the wider economy, including inflation levels.
Inflation and Interest Rates
Inflation is the rate of rising prices over time, and it is used to measure how quickly store prices, wages and so on are rising. For instance, if a block of cheese is $1, and it rises to $1.02 over a month, that is a 2% inflation level. In reality, the inflation rates quoted by governments and economists usually refers to the overall change in the price of a package of goods that include a variety of things we all buy regularly, known as the Consumer Price Index.
Inflation can be pushed upwards in two ways, cost-push inflation, where prices are rising due to the rising cost of the materials or other components that create the product, such as wages, also going up. The other is demand-push inflation, where prices rise because the demand for the product is high.
Interest rates and inflation are directly connected, although it may not seem obvious at first glance. In fact, interest changes are the most commonly used tool for central banks when seeking to control inflation. This is because interest rates have a direct influence on consumer spending. In general, the higher the rate, the costlier loans, and finance become, and the fewer people are able to spend on credit.
Because a significant level of consumer spending is credit-based, then reducing credit availability by increasing its cost also reduces demand as consumers cannot afford to buy as much. Reducing demand leads to oversupply, which deflates prices, reducing inflation. In effect, it is the opposite of demand-push inflation, and a valuable tool for ensuring inflation does not reach damaging levels.
When you see the connection between interest rates and inflation, you can also begin to understand why interest rates matter for the stock market. Inflation can signify an increase or decrease in demand, and of course, that has a direct effect on the stock of manufacturers and providers of goods and services affected by that change in demand. So, given that we know interest rates can affect the stock market, what does that effectively mean?
Inflation and the Stock Market
As we have seen, inflation levels are important to business, as it has a direct effect on demand for their products and services, and that is why everyone, from the businesses themselves, to investors and central banks, constantly monitor inflation levels. Because rising inflation means higher prices and reduced demand, which in turn slows the economy.
That manifests in the stock market too, and for many, stocks are a great hedge against inflation, as company profits should rise at the same rate as inflation after an adjustment period. However, because government monetary policy also influences this, it is not a certainty.
In general, historical evidence of US markets suggests that value stocks, those that are trading at lower levels than their dividends and earnings would suggest, perform better in high inflation environments. In contrast, income-generating stocks, stocks that yield regular, increasing dividends, are a better option when inflation is low.
Cost of Borrowing
For both individuals and business, the cost of borrowing is an important aspect of their financial health, and it is directly related to interest rates. For businesses that borrow to invest in new equipment, facilities, product lines, or an individual with a mortgage, the cost of borrowing is the amount needed to be repaid beyond the initial loan value. That cost is calculated by the interest charged over the life of the loan.
Interest rates for loans are usually based on the base interest rate from central bank plus a percentage for the bank that includes profit and risk levels. What that means is that as interest rates rise, so does the interest level on loans. While in some cases loans will be offered at a fixed rate for a set period of time, in the end, they revert to the current interest rate, and again, that adds to the cost of borrowing as the interest rate rises.
Stock Market Returns
With higher interest rates seeing reduced investment from business, and demand falling as consumers have less money to buy, the markets are affected negatively by
Reduced investment leads to lower growth, and it can have a negative effect on a stock price, and higher interest rates often see a downturn in the markets as a result. There is profit potential in a falling market, and those falls often lead to undervalued stocks that offer great profit potential as the fall reverses once interest rates stabilize once again.
There are exceptions to this, financial stocks, such as banks, mortgage companies and so on, see increased earnings from higher interest rates, and stocks will often rise in value.
In general, when looking at the effect of interest rates on stock markets, it is the combination of interest rate and monetary policy that dictate markets, and often, as is the case today, rising interest rates (albeit from historical lows), can actually result in rising markets too.
Current Cost of Money
Today, the interest rate set by the Federal Reserve is 2.25%, which is low if we look at the history of interest rates, but actually a rising rate in today’s economy, going up from 1.25% 12 months ago. After the 2008 financial crash, rates were kept at historically low rates, less than 0.5% until 2016, and only recently rising above 1%. At the point of the financial crash, interest rates were around 5%, and twenty tears previously as high as 20%, with a steady decline in the rate in the period between the two. In that context, money today is as cheap as it has ever been.
Since the interest rate started rising in 2016, markets have risen sharply, with some, such as the Dow Jones Index, reaching record levels.
Interest rates affect the whole economy, from expenditure to demand, inflation to investment, and they do have influence over stock markets too. However, as we currently see, while we may expect stock markets to fall in high-interest rate environments, monetary policy and other economic contributors can result in high-interest rates and rising markets as well.