the impact of interest rates on everything 20221
Why interest rates are important
Before we delve deeper into understanding its importance, let's start with the basics. Interest rates are the cost of borrowing funds, expressed as a percentage of the loan amount.
It is basically a fee charged by the borrower for the use of the asset. Interest rates have been referred to as the "cost of money" in some sources.
Interest rates , by themselves, do not affect the economy as much as you might think. It is the combination of interest rates and credit that affects the economy.
Credit is something that is created out of a vacuum between the lender and the borrower.
When a person agrees to repay a loan, this is the time when a credit is established for that transaction. When the loan is repaid, the transaction is considered repaid and the credit disappears.
If you would like to learn more about how the economic machine works including the role of credit .
However, the volume of lending and borrowing largely depends on interest rates.
For the economy to be healthy, there must be a certain level of lending and borrowing taking place at any time. This is because people usually borrow money to do things, such as investing in a business, buying assets, etc.
This creates demand, which in turn creates supply to meet demand. However, if there is too much borrowing and not enough is repaid, then we have a problem.
Interest rates for consumers
As a consumer, interest rates influence the financial decisions we make, especially whether we will save or borrow.
Low interest rates encourage us to make better use of our money by spending or investing while high interest rates make it irrational to save more.
When we spend, money is circulating within the economy, passing from one hand to the other. When we save, the money is deposited in a bank or invested.
It is important to note that money is deposited in the bank not only as a deposit. The bank will use it to make loans to other people. However, higher interest rates lead to less borrowing, which reduces the likelihood of lending money.
On a personal basis, this may affect our spending habits as we may spend less and decide to save more when rates are high. When prices are low, we are more inclined to spend more because money is considered cheap.
If we are looking to buy an expensive item, we may postpone buying it when prices are high because it is expensive to borrow. We may want to put more money as a down payment on the initial cost so that we don't have to borrow as much.
Those who already have some kind of debt are motivated to pay off their debts as quickly as possible when rates are high. Lower rates mean that debt repayment is slower because people may feel that money is better used elsewhere instead of paying off debt.
Corporate interest rates
As an employer, business decisions often revolve around factors that can bring more profit or reduce costs. One thing that affects these factors is the current interest rate.
It is no exaggeration to call it a hidden hand that directs business. This is because the types of activity carried out or the options available largely depend on the prevailing interest rates.
If a company wants to expand its operations, purchase new equipment, hire more employees to meet demand or anticipate future demand, it is better to do these actions when interest rates are low.
Apart from expansions, consumers tend to spend more when prices are low, which leads to new demand, which puts the business in a positive cycle. Listed companies may experience a rise in their share prices due to good earnings.
When the rates are high, not only will the company not take on more debt, but it will also want to pay off existing debts as quickly as possible without affecting profit margins, because paying off the debt costs more.
Despite this, sometimes companies cannot afford to pay their debts when interest rates are too high, even if the increase is only 1% or less.
When this happens, they may have to look for ways to reduce costs, including letting employees leave, which further aggravates the situation.
The reason for this is that high rates discourage consumers from spending, which leads to a decrease in demand and even a decrease in the need for supply.
Henry Ford is famous for wanting his workers to be able to buy the cars they make. When your employees can't buy the products you make, assuming they're not luxury goods, you know things are pretty bad.
Interest rates for investors
Investors perceive money as a product and the cost of money is interest rates. The base cost is the ten-year Treasury bond rate, also known as the risk-free rate.
Stocks and other assets are usually perceived as riskier assets in comparison, and therefore the investor wants their investments in those areas to bring higher returns than Treasury bonds provide.
The rate of Return of such assets is known as the risk premium. If the Treasury rate is 2%, and investors want to get at least 4% of the shares, then the total rate of return they need is 6%.
What affects the risk premium may also be influenced by interest rates. As we have seen in consumer behavior, higher rates lead to less demand and, consequently, less supply. When this happens, the company's share price decreases due to a decrease in profit.
There are also other factors that affect the risk premium such as the resignation of competent employees in the senior management team, or a company that is having trouble servicing its debts.
The sequential effect of rising and falling interest rates is something that investors are very interested in when evaluating available investments or what to invest in the future.
Interest rates and countries
When we look at interest rates from the perspective of a country, the decisions that are made are influenced by various factors compared to those that affect consumers.
Basically, there are three main areas of interest:
Central banks and interest rates
The Central Bank of the state is the Bank of banks. It's where banks go to borrow money. The central bank is also responsible for setting the interest rates used in the country.
This figure is what banks will receive for deposits and pay for borrowing money from the central bank. It is also used as a guideline by banks to decide how much they will lend to lenders and charge borrowers.
When the central bank sets a high interest rate, it stimulates consumers to deposit money in the bank. This is because you can get a decent return on bank deposits, which are largely risk-free money.
The desired effect leads to the withdrawal of money from circulation from the economy, thereby reducing the amount of funds available for use. Less floating money means chasing less money for goods, so prices fall and inflation remains under control.
Most central banks around the world agree that it is better to err on the side of inflation, therefore an inflation rate of 2% is a common goal of central banks.
If the rates are too low, it may look good for the economy as people spend more, which leads to economic growth. However, it is also very easy for things to turn upside down, which leads to excessive borrowing or increased leverage.
An example of this is using a 20% down payment to get a mortgage for your first house, then using the first house as collateral to get your second home, and before you finish paying the mortgage for both, you decide to take a third property that uses both houses as collateral.
If you want to learn more about how to take advantage of catastrophic effects .
Another way for the central bank to keep the economy volatile is the privilege of being able to create money out of thin air.
They do this by printing money, which used to be a physical act of issuing new dollar bills. Nowadays, it only takes a few clicks on a computer.The Act's fundamental elements have not changed.
This is an important point to consider because "printing" increases the amount of money chasing goods currently in circulation.
Most goods are not produced as quickly as required by the appearance of additional funds in the economy. Eventually, you will reach a point where more cash is available to pay for things. This is how inflation occurs.
How smoothly the economy will run is largely influenced by the decisions made by the central bank.
What makes the central bank's task difficult is how to achieve an optimal balance so that there is not too much or too little money in the economy.
A lack of credit can stifle growth but control inflation while an overabundance of credit is good for the economy but encourages inflation.
As we continue to look at other areas affected by interest rates, you will also see the actions and options available to central banks to deal with these problems.
Fiat currencies and interest rates
If there is a classic example of "I say so" money, it is paper coins. This is because each country has its own currency that is only valid for its borders, but is often useless outside those borders. The exceptions here are the US dollar and the euro, which we will touch on later.
However, this was not always the case because the currency was backed by gold. A paper invoice is only equal to the cost of printing.
What gave it value in the past was that it could be exchanged for gold at a certain price set by the government. When the gold standard was abolished, what supported the currency was the economic power of the government.
What gives a government power is its perceived ability to set sound economic policies, keep the national debt at manageable levels, and ensure the health of the government bond market, to name a few.
Apart from economic considerations, other factors are also taken into account such as the government's ability to protect the country's borders and its citizens.
The local currency of each country is also a product that is traded on its own market, known as the forex market, short for foreign exchange.
Buying and selling currency is a trillion-dollar business and interest rates play a big role here. Every trade always involves a currency pair because you need one type of currency to buy another.
Carry trade, as it is known, is when buyers buy a high-interest currency against a low-interest currency and earn daily interest between the difference.
What makes a currency considered high or low interest is also related to the currencies of other countries.
It's fair to say that while everyone is primarily focused on the health of their countries, everyone is also watching what their neighbors or competitors are doing when it comes to setting interest rates.
This is because countries are also competing for foreign monetary investments with each other. In order to attract foreign investment, prices are reduced, which makes investment in this country attractive.
On the contrary, prices are raised to prevent the outflow of funds outside the country.
World Trade and interest rates
Goods are imported and exported by all nations. What they import is not necessarily something they do not own or produce, it may be that what they produce can be sold at a higher price and they can import the cheaper version for internal use.
However, some countries are in a position to import more than they export and vice versa for others. Import-driven countries need their currency to be high-priced so that the goods they buy are cheaper.
On the other hand, export-based countries need a low currency so that what they produce is affordable for other countries.
At this stage, we need to talk about the world reserve currency, which is the US dollar. Since a lot of trade is carried out using the US dollar between countries, the closer the currency is to the US dollar, the stronger it becomes.
This is good news for importers but bad news for exporters. Countries that accumulate poorly against the US Dollar need to use more of their currency to buy things for their citizens. In some cases for countries with heavy exports, they have a special interest in keeping their currency weak against the dollar so that their products become more saleable to other countries.
Along with low interest rates, countries with a strong currency tend to buy more as it can be considered a kind of discount. However, this is also a delicate balance because it will also make their imports expensive.
What is clear is that it is important for every country to have a proper balance of the US dollar in its national coffers. In the worst case scenario, you will be faced with a situation like Sri Lanka, where national coffers do not have enough US dollars to purchase fuel and other necessities.
The strength of the US dollar is determined by the rates set by the Federal Reserve, which is the Central Bank of the United States.The strong US dollar also makes it difficult for countries to service their debts to other countries because they need to use more local currency to pay off the debt.
The United States is also no. The No. 1 creditor country worldwide, that is, it lends most of the money to other countries. When interest rates rise in the United States, not only do other countries need to worry about paying off their debts to other countries, they also have to worry about their own debts to the United States.
That is why when the Fed announces changes in interest rates, the world listens.
Speaking of the world's reserve currencies, there has also been some heated debate about a different type of currency replacing the US dollar, a more neutral type of government. So that's interesting.
Interest rates and investments
All types of investment are directly impacted by interest rates. First of all, it affects the amount of money spent on investments.
Less money is available for hazardous assets when interest rates rise. In a strong economy with low inflation and high job security, people are more inclined to invest because there is more cash that can be spent on their part.
The reverse is also true. We will take a closer look at how three areas of investment are affected by rising and falling interest rates.
How interest rates affect stock markets
Interest rates affect the stock market in two ways: through the stock price and by influencing investors.
You may have noticed that anytime an interest rate hike is announced, the stock market usually experiences a decline. How quickly the decline will occur depends on whether the market expects an increase.
If everyone expected an increase of 1% and the ad says 1.5%, the decrease would be much greater. If the actual rate increase is lower than expected, the stock markets may remain the same or even experience a small rise.
This is because the given signal indicates that things are not as bad as expected, and therefore there is no need for a big hike.
When interest rates are high, borrowing money becomes an expensive activity.To pay off their debts, businesses must increase their profits.
This makes it less profitable for investors. High-growth stocks, including small businesses, startups and companies that use borrowed funds to fuel growth, are the most affected.
At the same time, high interest rates weaken demand, which leads to a reduction in business for companies, which means that stock prices do not rise as much. Another bad news for investors.
Companies that are more established or have a larger war chest, are able to withstand higher interest rates better.
Their debts remain serviceable without devouring much of the profits, and while they are also affected, the disruption is less intrusive compared to companies that rely on highly indebted borrowing.
Oddly enough, although most people are familiar with the motto "Buy low and sell high," when stock prices fall, many do not want to get what could be bargain deals.
Perhaps the reason is that they may not have the money to buy these stocks as they may be busy servicing their debts or doing some serious budgeting for their own money.
Another reason that can be attributed simply to human nature, driven primarily by fear. When stocks start to fall in a high-interest environment, no one wants to buy too soon because they are waiting for the bottom. Nobody knows when the bottom will come.
Not only that, there is also a fear that some companies may not survive.Due to their unwillingness to risk good money on a bad investment, investors are less likely to invest in them.
However, it is precisely at these times that one can see the real backbone of the company. Those who truly believe in the company's ability to weather severe storms and vote using their wallet may see significant returns when the storm passes.
Companies will also have to prove that they have what it takes so that this trust is not lost.
This swing of emotions oscillating between fear and greed is most clearly seen when interest rates are rising.
Extreme fear creates opportunities, and extreme greed means time to sell.
The effect of the interest rate on the bond markets
Any mention of the bond market is usually indicated by one of two: government bonds and those issued by private companies.
The former make up the lion's share of the bond market while the latter is only a smaller part. Regardless, bonds usually do well in a high interest rate environment.
This is because bond yields rise as prices rise, and they are usually seen as a safe alternative to stocks.
Government bonds are the most risk-free investment you can make. You are basically lending government money and it promises to repay it based on a predetermined time including some interest.
During World War II, wartime bonds were a popular offer and a way for the government to raise money instead of raising taxes.
It has been a key element of many investor portfolios, representing the safe part of their investments. However, with low rates before 2022, bonds were considered a terrible investment because they paid almost nothing.
When inflation came and rates had not yet risen, it was like losing money and had a huge impact on the most conservative wallets. When interest rates started to rise, it was when bonds felt less losing as they were a few years ago.
Needless to say, higher interest rates are good for the bond market because people see it as a good place to store money.
When it comes to corporate bonds, the story is a little different. Instead of lending money to the government, you are lending it to the company.
Keep in mind that the price of a bond is not about the future growth of the company that issued it, but the interest rate of what the bond pays.
The growth of the company is important insofar as it indicates the likelihood that the company will be able to repay the loan within the specified period.
Interest rates on short-term and long-term bonds are different, both for the government and for companies - as it should be. The former offer a lower return than the latter.
In the kind of environment we currently find ourselves facing, where every few months new highs bring new rates with a healthy scoop of uncertainty thrown into the mix, Bonds with short maturities could be a smart place to save some excess money.
Use them to overcome any price changes and as soon as funds become available, you can rethink your strategy and see what you can benefit from in the current environment.
The effect of the interest rate on cryptocurrencies
Due to its speculative character, cryptocurrencies are regarded as a high-risk asset class. The thing is that anything can be a reason for speculation.
What makes some assets more suitable for speculation than others is the basis for the occurrence of speculation. As long as there is a factual basis on which to draw, speculation can grow as much as people are willing to believe it or expand their imagination to it.
When there is speculation, the theory of the biggest fool follows closely, and here profits can be made.
Crypto represents one of the latest financial technologies that can bring improvements with the potential to change how society as we know it works. This in itself is a fertile ground for speculation to grow and flourish.
Of course, announcements about raising rates affect cryptocurrencies in a similar way as the stock market. When interest rates are high, the appetite for speculation weakens as there is less need to put oneself on the fringes to chase high returns.
When rates are low, and if combined with high inflation, people feel that they have little to lose, and therefore are more willing to engage in risky activity. This, in turn, affects the market prices of assets.
Interest rates and the housing market
There is no doubt that interest rates play a major role in the housing market. Prices grow when interest rates are low and halt, or even decrease, when interest rates are high.
Very simply, people think twice about buying a house when they look at the amount required to service a mortgage. Affordability is the first thing to be considered, followed by the measurement of risk and gain.
How much will the price of the property rise when I am ready to sell Is it enough to cover the costs of owning a property.
At one time, the first payment made for the property could reach 30% (or more), while the interest rate charged for borrowing the rest could reach 15%.
In those days, the general assumption was that people would buy what they could afford with a reasonable time to repay the loan, which would then enable them to throughout the remainder of their days, delight in the property.
With low interest rates , and rising house prices, people have been encouraged to take on more debt while asking for less down payment.
Even if they are able to pay off the mortgage sooner than expected, low interest rates may prompt them to rethink how best to put their money to good use.
This is all well and good. However, when interest rates rise, it changes the equation a little. Not only is the high cost of mortgage payments, but also whether the debt itself is serviceable is also coming into question.
Interest rates also significantly affect real estate investors. Just like any other business, what they can get credit for by leveraging their assets as collateral is determined by how expensive it is to borrow and repay the loan.
The best scenario is to borrow when the rate is cheap and repay it in full (or at least most of it) by the time prices rise.
How interest rates affect inflation
Inflation, in the most basic sense, occurs when you have a lot of money chasing the same amount of goods. At this stage, it is important to distinguish between value and price.
An item's value is not always reflected in the price that was paid for it.Part of the value comes from the cost of its production. Inflation affects the price, not the value.
When interest rates are high, people may not choose to deposit money in the bank but instead use it to invest in other things. This is because they believe that they can get a better return than they get from the bank.
As we all know, every investment comes with risks, some greater than others. Higher-risk investments usually come with greater rewards. The least risky option is bank deposits.
If so, the money is still in circulation and does nothing to ease inflation. When that happens, the central bank will have no choice but to continue raising interest rates, hoping to suck more money out of the system.
On the other hand, the interest rate itself is also the basis for what borrowers need to repay for the loan. If the interest rate is at 1%, the borrowing rate can be 3%.
Repaying the loan also takes the money out of circulation because the money goes back to the bank. You can imagine that people find it difficult to repay their loans if interest rates are too high.
Too much money taken from the economy can lead to deflation, which is also undesirable.
Some of you may be wondering: why 3% Why not 2 or even 1.5% for the borrowing rate That's a valid question.
The economy's access to credit is affected, is the answer.As we read earlier, credit is something that can stimulate the economy by creating demand that causes supply to meet demand. Lack of credit the economy faces the risk of recession while too much credit forms bubbles in the economy.
Conclusion
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One of the invisible factors plaguing us in modern times is interest rates. What we see in the form of bank rates is only the tip of the iceberg. Almost every economic activity is affected by it because it is the cost of money.
Our daily life is also shaped to some extent, whether we like it or not. The only thing that can help us is to go with the flow and let our actions be guided by the next pleasant payment of rates. Wherever possible, grab some spare cash to pick up some good investments.
While some may see cash as waste, in the short term, it is still very useful and having some in the bank is not a bad idea. Sometimes maximizing what you have can lead to the opposite result when interest rates rise. In the long run, it is best to prepare for both low and high rates.