What is the relationship between interest rates and financial markets?

Have you ever wondered about the relationship between interest rates and stock markets? Take a couple of minutes and make yourself comfortable: today we’re going to explain exactly that. Obviously, as always, with simple words.

When interest rates are low

In the phase of a business cycle where interest rates are very low, many things are happening simultaneously.

Borrowing money is cheaper

This is the perfect time to get out of debt. Those who have to buy a house apply for a mortgage taking advantage of low rates; those who need to buy a new car choose to do so now by being able to take out a loan at lower rates. In summary, low rates support consumption, stimulating demand. The increase in demand for goods and services increases industrial production; therefore, corporate profits are projected higher. Low-risk bond investments are unprofitable precisely because of low interest rates, and therefore the world of equities is preferred, driven up by the growth in consumption. It sounds like an investor’s playground, but it can’t last forever. Do you know why?

Inflation starts to rise

The increase in demand for goods and services leads to a general increase in prices. The more a good is in demand, the more its price increases. It is the oldest and best known law on the market. A general increase in the prices of goods and services is called inflation, leading to a decrease in the purchasing power of money. For example, suppose that yesterday I paid 10 euros to buy something and today to buy the same thing I paid 11. In this case, it means that the purchasing power of the currency has decreased by 10% and the salary I receive today is worth less

How do governments fight inflation?

To mitigate the effect of inflation, central banks raise interest rates, thus triggering the reverse process. People are starting to borrow less because mortgages and loans now have more expensive payments; they have to spend more to repay interest on unpaid debts and consume less. Companies therefore sell less and lower their estimates of future earnings. At the same time, the rise in interest rates makes bond instruments more attractive.

clearer ideas

We learned an essential rule: when rates are low, the scenario is generally positive for the equity environment and less attractive for the bond universe. But, conversely, in a context of high interest rates, it is exactly the opposite: the world of equities becomes less attractive, while bond yields become attractive.

However, it’s not that simple

Now that you understand this relationship between interest rates and financial markets, do you immediately want to run to invest? Hold for a moment: everything is not so simplein particular for the following reasons:

  • the different world economies are at the same time positioned at different levels of the economic cycle. For example, the American economic cycle is today much more mature than that of Europe. Moreover, the rate hike in the United States has already started for some time. And since the economies of the different states are, anyway, very interconnected with each other, these aspects must also be assessed.
  • While the real economy needs time for upward or downward movements in interest rates to materialize, the financial world generally anticipates these phenomena and reacts before they occur. It even tries to understand, through the declarations of the central banks, what will be the actions to come, trying to anticipate them.
  • You may sometimes see market reactions that violate the newly learned rule. Let’s try to explain it to you with an example. If the market had bet on an imminent 0.50% hike in interest rates, but the Central Bank had formalized a 0.25% hike, we will see a euphoric reaction from the stock markets, but in the presence of a rate hike… This is because stock prices had already adjusted incorrectly to an expected 0.50% rise in interest rates.
  • Finally, variable interest rates, although important, are not the only ones to influence the performance of stock and bond financial markets. There are many other factors, including geopolitical and demographic ones.

Conclusion

What lessons can we learn from what has been said so far? The most important lesson is that a good investment portfolio must simultaneously include stocks and fixed income instruments to always have profitable instruments at any stage of the economic cycle. The mix of stocks and bonds will no doubt depend on the investor’s risk appetite and time horizon, but it’s good to have both components present. A good financial advisor will certainly be able to identify the right composition and the right instruments related to your specific investment objectives.

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