How interest rates can affect your investments
Talk of Interest rates is usually boring and dull, but they have been all the rage recently with everyone wondering how far interest rate rises will go and the impact on their pockets. Loans and mortgages have taken a massive hit of course, but for the first time in over a decade, savers are earning a decent return on their savings accounts. Investments, on the other hand, can suffer from rising interest rates and it pays to understand how they affect the financial markets and therefore your investments.
What are interest rates?
When you borrow money, you’re charged interest. This is the charge the lender charges you for tying up its money and covers the possibility that you might not pay it back. When you save money, your bank pays you interest. It will use that money to lend to others and will compensate you with a small (let’s call it a paltry) slice of the money that it earns on your money.
The fees you’re charged, or the income you receive, are usually expressed as an annual percentage and the interest rates are based on one underlying rate – the Bank of England’s base rate, which is the rate that the UK’s banks borrow from the Bank of England (BoE). Because financial institutions pay their interest at that rate, the rates they charge you are based on it – only slightly higher of course.
If the BoE raises or lowers the base rate, banks will probably increase or lower their interest rates too. That has a knock-on effect on the entire economy: a rate change can send stocks and bonds flying, change currency values, and even trigger or avoid a recession. We’ll explore that in a bit more detail.
Why does the Bank of England change rates?
The Bank of England (BoE) and other central banks use interest rates to help the economy – either by heating it up or cooling it down. Low interest rates keep the cost of borrowing down and galvanise economic growth because companies are more likely to borrow when loans are cheaper. Companies may use the loans to expand, for example by opening new branches, or creating new products and employing more people.
Lower rates also make it cheaper for consumers to spend on credit – so personal consumption (particularly of high-value items like cars and houses) should tick up too. If an economy seems to be faltering, low interest rates can prop it up on two fronts.
So why does the Bank of England raise rates?
It’s the classic supply and demand scenario. When the economy is growing rapidly and demand for goods and services exceeds supply, businesses can increase their prices, creating inflationary pressure. Global supply chain issues following the pandemic were experienced all over the world and led to rocketing demand and a dramatic increase in prices. There was also global shortage of labour, meaning that businesses had to pay higher salaries to attract and retain employees.
The rapid rate of price increases can make it difficult for households and businesses to save money or plan for the future. In that scenario, a central bank might raise interest rates to slow economic growth or bring down inflation. Higher borrowing costs will put businesses and people off from spending, reducing the demand for goods and services. Lower demand should keep a lid on price rises and bring inflation into check.
How often does the Bank of England raise rates?
The BoE’s job is to maintain monetary and financial stability and that includes moderating inflation and unemployment. The BoE’s Monetary Policy Committee meets eight times a year (roughly every six weeks) to discuss and decide whether to raise, lower or maintain rates.
Following the Global Financial Crisis, rates stayed at a record low for many years before beginning to slowly rise. The pandemic saw temporary slashing of rates to boost the economy, but in the last two years, UK rates have risen rapidly to 5.25% to combat rampant inflation (as at 31 Oct 2023).
Changing rates is always challenging and difficult. It takes time for base rate changes to show in the economic and employment statistics – it’s a bit like using this summer’s heatwave to decide your central heating temperature over the winter!
When rates change, the equity and bond markets move too. Let’s explore that in more detail.
How do interest rates affect bond prices?
When investors invest in bonds they’re essentially lending the government money at the current interest rate. If interest rates go up, investors will want to dump existing bonds with the lower interest rate to buy the ones paying the new, higher rate of interest. As a result, bonds that are currently in the market go down in price when interest rates go up.
Short-term government bonds are a type of low-risk loan and therefore closely mirror base rate movements. When the base rate rises, the price of existing bonds will fall until the yield, which is their interest rate as expressed as a percentage of their price), is similarly high – which means the price of the bond can drop significantly. The price of long duration bonds will be less affected but can still change – especially if the BoE has given its views on the direction of travel.
Because the UK is viewed as a safe bet (it’s highly unlikely to fail to reimburse investors), the price on riskier bonds will also move. No one’s going to take on more risk unless it’s rewarded by higher returns – so higher government interest rates also force existing corporate bonds (or dodgy countries’ government bonds) prices down until their yields are on a par.
How do interest rates affect the stock markets?
The impact of interest rates on bonds is clear and evident, but it’s harder to see the impact on stock markets. Overall, low interest rates are good for businesses because cheaper financing options allows them to expand and continue to invest in their businesses, operations and employ people. It’s a goldilocks scenario though, not too high and not too low – if the BoE slashes rates to avoid a recession or boost the economy, investors can also get nervous about company prospects and sell off stocks.
Cash isn’t always king
When the base rate changes, the interest rates banks pay out to ordinary savers will often change too. That means an interest rate hike makes saving more attractive and a cut does the opposite. But banks won’t pass on the full increase – banks like to pocket some of the extra interest than give it to you.
Saving money is a good habit to have, but in a high interest high inflation environment, it may not be the best way to grow your wealth. When inflation is high, the purchasing power of your savings decreases over time. This means that the same amount of money will buy you fewer goods and services in the future.
How interest rates affect currencies
In today’s global economy, investors can put their money in more or less any country they choose. That means economies compete when it comes to interest rates.
If the US has interest rates of 1% while the UK’s paying 5%, it won’t make sense to invest in US bonds: as you could get a much better return in the UK without taking on much more risk, as neither government is likely to default (even if Brexit is really bad). Smart investors will therefore buy the British pounds necessary to buy British bonds. And that demand for the currency means the pound will increase in value.
But if only it were that simple! If a country has high interest rates and persistently high inflation, investors might be worried about the value of their cash getting eroded over time and decide not to place their money there, which would de-value the currency.
If the pound goes up in value, spending abroad is cheaper – a stronger pound can buy more euro-priced products. But it would also cost Europeans more euros to buy British stuff, so British exports might fall as Europeans avoid their too-expensive products and buy elsewhere. If the imbalance gets too big, businesses and consumers can suffer from consistently high prices and that would drive inflation too.
How should you invest with high interest rates and high inflation?
High interest rates and high inflation can be a challenging environment for investors, but there are still ways to make your money work for you. Here are some tips for how to invest in this climate:
Focus on real assets
Real assets, such as commodities and property, tend to hold their value better during periods of high inflation. This is because they are essential goods and services that people will always need, even if prices are rising.
Some examples of commodities that you could invest in include gold, silver, oil, and agricultural products. You can invest in commodities directly or through commodity funds.
Property can also be a good investment in a high inflation environment, but it is important to choose carefully. Look for properties in areas with strong demand and good potential for capital growth. Again, the best way to get diversified property exposure is through property funds.
Inflation-linked bonds
Inflation-linked bonds are government bonds that are indexed to inflation. This means that the value of the bond and the interest payments increase as inflation rises.
Inflation-linked bonds can be a good way to protect your savings from inflation and generate a steady income.
Invest in cyclical stocks
Cyclical stocks are stocks of companies that perform well when the economy is growing. These companies tend to benefit from higher interest rates, as they can charge more for their goods and services.
Examples of cyclical stocks include consumer discretionary stocks, such as restaurants and retailers, and industrial stocks, such as manufacturers and construction companies.
Invest in value stocks
Value stocks are stocks of companies that are trading below their intrinsic value. These companies may be out of favour with investors, but they have strong fundamentals and are well-positioned to grow in the long term.
Value stocks can be a good investment in a high interest rate environment, as they tend to be less volatile than growth stocks.
Diversify your portfolio
It is important to diversify your portfolio across different asset classes and sectors. This will help to reduce your risk if one asset class or sector underperforms.
In addition to the asset classes mentioned above, you could also consider investing in stocks of companies that are well-positioned to benefit from long-term trends, such as technology and healthcare.
Investing in a high interest rate, high inflation environment can be challenging, but it is still possible to make your money work for you. By focusing on real assets, inflation-linked bonds, cyclical stocks, value stocks, and diversifying your portfolio, you can increase your chances of success.
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