What is an interest rate?
An interest rate is the cost of a loan. It is expressed as a percentage of the total loan – whether cash, property or property. It is also the amount earned on deposits in a savings account.
When you borrow money, you pay back the original amount – the principal – plus interest. This means that the money repaid is greater than the amount borrowed.
Who sets interest rates?
Interest rates are set by a country’s central bank.
For example, in the UK, interest rates are based on the Bank of England base rate. By raising and lowering the rates at which big banks can borrow money from the BoE, the institution can influence the rates that are passed on to consumers and businesses.
Banks and building societies will set individual interest rates on loans based on various factors, but the main one is the risk of default. If a borrower is considered very likely not to repay the entire loan, the higher their interest rate will be.
How does inflation affect interest rates?
Inflation and interest rates generally have an inverse correlation. When interest rates are low, inflation rises, i.e. the cost of goods and services rises. And when interest rates are high, inflation is likely to decline.
However, it is important to note that this relationship is not set in stone because during crises it is possible to see low interest rates and little inflation. This was the case amid the Covid-19 pandemic.
One of the main tasks of central banks is to control inflation. They will have an inflation target that they will aim to meet in order to stimulate growth without the cost of living becoming too expensive. Essentially, that target is about 2-3% inflation per year.
Central banks will use the interest rate to manipulate inflation. By increasing or decreasing the cost of borrowing, they can influence the consumption habits of businesses and consumers. Let’s look at each scenario.
Rising interest rates have an impact on inflation
When central banks raise the base rate, it increases the cost of borrowing, which encourages banks to charge businesses and consumers more to borrow money. But it also increases the amount of interest paid on savings accounts, which encourages consumers to keep their capital in the bank.
This reduces spending levels in the economy, causing slower economic growth. The money supply will tighten and the demand for consumer goods will fall, which will have a ripple effect on corporate results.
Falling demand, without falling supply, should make goods cheaper and lower inflation.
Learn what to trade when inflation rises.
Falling interest rates have an impact on inflation
When central banks lower the base rate, the rates passed on to consumers and businesses are also reduced. It is therefore less profitable to hold savings in bank accounts and more interesting to spend money and take out loans.
This causes the economy to grow as more money comes into circulation, increasing demand for goods and services and increasing business income.
The higher the demand for goods, without an increase in supply, the more companies can charge for them. It’s inflation. Some inflation is good, but too much can harm the economy.
How do interest rates affect financial markets?
Interest rates impact the economy, businesses and consumers, so the effects are felt in financial markets.
To better understand the impact of interest rates, we will divide financial markets into risky and risky assets. All financial assets involve some level of risk, so we’ll avoid the term “risk-free asset”, but some are more dangerous than others when it comes to inflation and interest rates.
- Risk-free assets are those that are reasonably certain to continue to generate returns regardless of economic circumstances. Examples include bonds, notes and treasury bills (treasury bills)
- Risky assets are those that have significant price volatility depending on economic cycles. Examples include stocks, commodities and currencies
Interest rates and debt securities (bonds, notes and treasury bills)
Bonds and other debt securities generally have an inverse relationship with interest rates. The longer the duration of the bond, the more sensitive it is to changes in interest rates because it takes longer for decisions to be felt.
Bonds pay a fixed rate of interest to investors. If interest rates fall, this fixed rate becomes much more attractive to investors. But the easier it is to borrow money, the less companies and governments have to rely on bond markets, and so they can come up with low-yielding debt issues. So even if demand for debt instruments increases – driving up the price of bonds – yields are likely to fall.
Conversely, when interest rates rise, a bond may not be as attractive as leaving money in a savings account. Falling demand means that bond prices generally fall. Bond investors could now expect a higher return in exchange for taking on more risk.
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Interest rates and stocks
Any change in interest rates is usually felt quite quickly by investors, especially with the rise of speculators who specifically wait for the news to arrive.
When interest rates rise, stock prices tend to fall due to the negative impact on businesses. Consumers who put their money in savings accounts, rather than in goods and services, reduce earnings growth. Companies will then have less to distribute to investors and speculators could have a more negative view of the stock in the short term.
On the other hand, lower interest rates can be positive for equities due to increased spending in the economy. Corporate profits will rise, increasing the likelihood of dividends and an optimistic attitude from investors and speculators.
The impact of interest rates on the stock market is also highly dependent on current economic conditions – so context is crucial. When fears of an economic slowdown, low interest rates can be just as negative for equities.
For example, the Dow Jones index fell significantly in March 2020 when the Federal Reserve cut interest rates to near zero at the onset of the Covid-19 pandemic. Although low interest rates generally stimulate the economy, the containment measures have caused stock prices to fall.
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Interest rates and commodities
Historically, interest rates and commodities also have an inverse relationship.
One of the main reasons behind this is the “cost of carry”, which is the term used to describe the additional costs associated with holding an asset.
Research conducted by Harvard University found that when interest rates are high, the cost of storing commodities also increases. This makes companies less willing to hold long-term assets, which can reduce demand for commodities.
Add to this the tendency of investors to seek better returns in savings accounts, rather than holding gold or silver, commodity prices tend to fall.
However, as interest rates fall, the cost of holding commodities also declines. Companies are once again becoming more willing to stockpile commodities and investors are returning to riskier asset classes.
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Interest rates and currencies
Interest rates are a key driver of the foreign exchange market. The interest set by a country’s central bank is one of the major determinants of the value of a national currency. They affect how traders view one country’s currency against another.
When deciding which savings account to use, you would be more likely to choose one that offered you an interest rate of 2%, rather than just 1%. And the principle is the same for currencies.
The higher a country’s interest rate, the more likely its currency is to strengthen. This is because more international parties are encouraged to deposit their money in domestic banks as they offer a greater reward. The “hot money” increases the demand for the country’s currency, which drives up the value of the currency. This makes imports cheaper in national currency and more expensive in international currencies.
Find out which is the strongest currency.
Conversely, a country with a lower interest rate is considered more likely to have a weaker currency. As less foreign capital enters the country, it weakens the purchasing power of the national currency, making imports more expensive and imports cheaper.
Generally, FX traders will buy a currency with a higher interest rate and sell a currency with a lower interest rate. This is called a carry trade. The high interest accrued on the currency they purchased is added to any profits.
Learn more about forex interest rate strategies.
But while economic growth can take years to change, market sentiment can only take seconds. This is why macroeconomic report releases – like the Consumer Price Index – and central bank announcements are among the most important events for traders to watch.
Find out how the CPI impacts forex.
If there is a rise in rates, the national currency will appreciate. And if there is a cut, it will fall. But sometimes the markets are surprised and all bets are off.
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