You may have seen a lot of “interest rate hikes” headlines around.
Interest rates are generally one of the most talked about topics in the world of finance. But even more so when there’s another word bounding around - inflation.
Interest rates are a key tool when it comes to controlling inflation, which is the general rise in prices in an economy. Prices rising over time is normal but when prices start to rise quickly, it can become a problem.
And 2022 has started with prices rising faster than we’ve seen in a while. Both in the UK and across the globe, this has prompted central banks to turn to their toolbox.
In March 2022, the Bank of England and the Federal Reserve both raised rates by 0.25%, to 0.75% and 0.5%, respectively.
In this guide, we’ll give a brief intro to the world of interest rates and what rising or falling interest rates could mean for your investments.
What are interest rates?
Interest rates are a hot topic at the moment.
But when you hear them pop up (whether it’s from the BBC, at the pub or in the papers) the likelihood is people aren’t talking about the rate they get on their current account.
Instead, they’ll be talking about the interest rates that central banks set.
Almost every country in the world has a central bank. The UK’s central bank is the Bank of England, in the US it’s the Federal Reserve and in the Eurozone (they got really creative) with the ECB or European Central Bank.
Central banks have a few roles but the main one is to make sure prices are stable (in the UK the inflation goal is 2%) to support a growing economy and good employment levels. The official name for this regime is monetary policy.
Interest rates are the main tool central banks use to achieve their goals, as well as setting the Bank rate. This is the base rate that banks themselves can borrow money at. These rates are important because they influence the rate we can also borrow from banks and get on our savings accounts.
Some central banks also call on a second tool called quantitative easing and the key thing to know here is that it also serves to lower interest rates when in action.
How all this feeds into the economy is the important bit.
Lower interest rates will be passed on to consumers, making it easier to borrow money. This tends to mean businesses and consumers spend more and this provides a boost to the economy.
The reverse is also true. Higher central bank interest rates make it more expensive to borrow and act as a brake on spending.
Why are interest rates rising?
The one-word answer is inflation.
The slightly longer answer is still inflation but we can add a bit more colour.
In the UK (and it’s a similar story in the US and Europe) prices are rising at pretty spectacular rates when you compare them to recent history.
While the Bank of England says inflation is currently running at around 5.5% there are expectations it could head towards 8% over the next few months. These are not only the highest levels of inflation seen in decades but notably beyond the 2% target set by the Bank of England.
There’s a lot going on under the surface. One of the main drivers behind the current inflation is higher energy prices but supply chain disruptions and heightened demand are also factors.
How long prices are likely to keep rising isn’t clear. The latest rate rise also came with guidance from the Bank of England and the Fed that there are more rate rises to come this year.
History teaches us that inflation is not an overnight story. So it’s worth getting more familiar with how interest rate changes could affect your portfolio.
How will interest rates affect my portfolio?
Changes in interest rates impact different types of assets in different ways.
Ultimately, how your portfolio is impacted will depend on what’s in it.
How do interest rates affect stock prices?
Despite what the headlines tell us, the answer to this question is often not much.
Small increases in interest rates are unlikely to have any material impact on a company’s day-to-day operations.
That said there are certain sectors or businesses like banks and other financial institutions that make money from interest rates and do see an immediate impact. But for other types of businesses the direct impact of interest rate changes is mostly limited to the cost of borrowing.
Meaning as interest rates rise, companies that rely heavily on debt to fund their operations might find themselves paying a higher interest rate at some point in the future.
Even then, all companies need to be treated differently when it comes to debt, as most can and do use debt in some shape or form.
For a broader sense of how interest rates impact companies we have to go a bit deeper and think about second-order effects.
We’ll start with the economic ones.
The reality is that it’s not the interest rate change itself but the economic backdrop in which it occurs that’s important.
If economies are healthy and growing, gradually rising interest rates are to be expected and should be seen as nothing more than prudent.
The challenge comes, if rising rates come at a time when the economy isn’t that strong, perhaps growth is slowing. The fear here is that higher rates could pump the brakes on the economy so much that we enter a recession or period of low growth. Neither of which tend to bode well for company profits.
This could be particularly worrisome if an economy enters recession and rates are still low, as central bankers would lack the fire power to lower rates and stimulate growth again.
This is one of the reasons why Jerome Powell and co. seem to be in a hurry to raise rates this year.
However, raise rates ‘too much’ or ‘too fast’ and you face hurting economic growth.
This is important for stock markets as most companies rely on a decent level of economic growth to sustain growth rates. And while the interest rate per se might not cause too many problems, a high interest rate induced recession would be unwelcome.
On the other hand, if economies have been doing nicely, and inflation is picking up, if rates get hiked too slowly, price rises could spiral out of control, which would force policy setters into jacking up rates much further.
This might yield a very unhappy scenario where companies face a slowing economy and maybe a recession, but with inflation still running high. This ugly outcome is referred to as stagflation, but is thankfully quite a rare occurrence.
In any case, it's easy to see that policy setters are walking a tricky tightrope and how it all plays out is difficult to predict.
So while interest rates themselves may not pose a direct threat to companies, it's important to think through their implications when investing.
A good place to start when it comes to your portfolio is reminding yourself why you hold the companies you do in the first place.
Have a think about different scenarios that could pan out, the good and the bad. The key thing to determine is whether you’re still happy to be invested in this company. This way, whatever happens to rates you know where you stand.
Interest rates and stock prices, a quick look at the theory.
There is another aspect to how interest rates impact stock prices, though, and that’s about how shares are valued.
The theory goes that the price of any financial asset (stocks, property, bonds, even art) is the present value of all future profits or cash flow that it will produce.
And a company’s stock price is just this. An indication of what investors think a company is worth and what they are willing to pay for it today.
Working this out is done by a calculation called discounting. And while we won’t go into the details here, the important thing to know is that interest rates play a big role (are a key input) in this calculation.
When interest rates change, the output of this process i.e. the share’s current price changes. Typically when rates go down, the value will rise and when rates go up the value will fall.
Why does all this matter?
It’s not something to get too hung up on but it’s important to be aware of as it can explain a lot of the price swings that you tend to see around interest rate decision times. Particularly for stocks where the value to investors is further in the future. Cue growth stocks.
Growth stocks are those in spending mode in order to maximise future profits, which means they may not be profitable yet but the hope is that they will be at some point down the line.
These types of stocks tend to see a double whammy on their share price when interest rates rise. That’s because discounting is the process of converting a future value into today's value by dividing it by something called a discount rate.
When we’re gazing far out into the future, we have to discount (divide) by the discount rate multiple times. Five times if we are talking five years out, 10 times 10 years out and so on. So the further out the profit the more it is discounted to convert it back to today's value.
So for growth stocks, where a lot of their profit is in the future, a higher interest rate means a higher discount rate. Or put more simply, the number you're dividing by is bigger.
Putting this in the context of the technology sector sell-off we’ve seen in early 2022 might be useful.
Do the share price drops we’ve seen reflect the derailment of the businesses? Probably not.
Do the share price drops suggest that there may have had too much optimism priced in? Potentially.
Could the prices we now see be a fairer reflection of the businesses themselves and where they are at? Possibly but it depends on the business in question.
How do interest rates affect bond prices?
Bond prices tend to correlate strongly with interest rate changes.
Lower interest rates will lead to higher bond prices but lower bond yields (a yield is the return you stand to make from a bond).
The reason for this is that, when interest rates fall, people start buying bonds, as safe assets, that will pay them a higher rate of interest than leaving cash in the bank.
This leads to an increase in demand for bonds, which then pushes their price higher.
As a result of this higher price, the return investors see on bonds — or ‘yield’ to use the right financial lingo — goes down.
Again, the reverse here is also true.
Higher interest rates will generally result in lower demand for bonds. That means the price of bonds will be lower but the yields or on bonds will be higher.
How do interest rates affect real estate prices?
The main way in which interest rates will affect regular people when it comes to real estate is down to changes in mortgage rates.
Interest rates have some bearing on how mortgage rates are set. When mortgage rates go up, it becomes harder to borrow money and, consequently, harder to buy property.
This has positive and negative effects for both buyers and sellers.
As it becomes harder to get a mortgage, real estate owners may have to lower the amount they sell their property for, so that it becomes more affordable for potential buyers. The result of this is that it can be cheaper for you to buy a house when interest rates are higher.
The downside is that, because it is more expensive to borrow cash, you may be unable or unwilling to take out a mortgage. If this happens then more people will want to rent houses, something that’s only really good news for those that own rental properties.
How to think about interest rates?
How interest rate changes impact you will all come down to how your portfolio is positioned.
If you’ve been keen on growth stocks, your portfolio may be looking a bit more red than you’ve seen in a while. If you’ve taken a more diversified approach, you may not notice much difference at all.
Crucially, interest rate changes shouldn’t lead to a wholesale approach to your investment strategy but act as a nudge to remind yourself why you are invested in what you are and how different economic environments might impact your investments.
For some practical steps, we’ve written about how to prep your ISA portfolio for rising interest rates.
With higher levels of inflation, it's also important to check in on how much cash you hold.
Again, you’ll find some practical tips in this piece on your portfolio and cash.
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