by Russ Allen, Online Trading Academy Instructor
Online Trading Academy Article of the Week
Interest rate changes have broad and deep implications for your investments. In the next couple of articles, we’ll explore this with the goal of knowing how to position ourselves for the changes to come.
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In the United States, and in most of the rest of the world, interest rates are at or near historically low levels. These ultra-low rates were first put in place after the financial crisis of 2008-9. At that time, central banks sought to encourage borrowing, spending and debt-based growth. This was to counteract the effects of the vaporization of trillions of dollars of value in the stock and real estate markets following the implosion of the subprime mortgage market and the rest of the dominoes that fell as a result; and the ensuing recession.
These historically low rates have persisted for eight years now. However, rates have finally begun to rise in the US, with the discount rate moving from ¼% to 1-1/4% over the last year and a half. Central banks in Canada and the UK are likely to begin raising rates soon, and even the European Central Bank is indicating that it might begin raising rates.
If the reason for the rate increases is that the economies are now strong enough to handle higher rates without slipping back into recession, then a gradual raising of rates to more “normal” levels would be a good thing.
In the US, the Federal Reserve has a dual mandate – to keep both inflation and employment within acceptable bounds. Controlling short-term interest rates is one of their primary tools.
It should be noted that there is no constitutional authority for the government to control interest rates. In fact, the Federal Reserve is not a government entity, but an unusual public-private hybrid. It is a corporation whose stock is owned by the commercial banks that make up the system. The banks receive dividends on their stock in the Fed. But the Fed’s Chief is appointed by the President and confirmed by the senate.
In any case, when the Fed changes the short-term rates at which banks borrow and lend money among themselves, those rate changes ripple out through the entire spectrum of debt instruments.
Why Lower Interest Rates?
In general, lowering rates is designed to encourage borrowing, spending and debt-fueled capital expenditures. All of these things become cheaper than they otherwise would be. When you lower the cost of doing something, you get more of it. All of these things represent, or lead to, more economic activity, which should be good for corporate profits and ultimately for jobs.
Lower rates also discourage saving in the form of bank deposits. With yields near zero, savers are forced to move to riskier investments like stocks and real estate, which in turn should help reflate these markets. That was also part of the policy of ultra-low rates.
Once the economy is back on its feet in terms of asset re-inflation, then the low-rate punchbowl can be withdrawn gradually. Leaving it too full for too long would ultimately lead to debt loads on households, companies and governments becoming too large to be sustainable – another financial bubble.
Why Raise Interest Rates?
Raising rates tends to have the opposite effects of lowering rates. Saving becomes more attractive, both in the form of bank deposits and in the form of paying down debt. And with higher yields on bonds, money will be drawn from the stock and real estate markets, as well as commodities, back into the bond market. This should lead to a slowing growth in those markets.
Thus, the Fed walks a fine line between too much stimulus on the one hand, which inflates bubbles in stocks and real estate which must eventually pop spectacularly; and too much restraint on growth on the other hand, which could reduce capital expenditures and employment immediately.
Consumer price inflation is the other half of the Fed’s mandate, along with employment. When the economy becomes very strong, normally costs of all inputs, including materials and labor, begin to rise due to increased demand. If companies can pass these costs on, maintaining their earnings growth rates, then their stock prices can continue to rise. Consumer price inflation will also result from their passing through their cost increases. Accordingly, a moderate amount of inflation can coexist with rising stock prices. When inflation becomes excessive, however, often companies cannot pass on their cost increases fast enough, resulting in lower earnings and stock prices, and eventually layoffs. So, a little inflation is good for the economy as it is currently constituted, while too much inflation is bad.
Another piece of this puzzle is that in times of rapid growth in the economy, interest rates naturally rise in response to increased demand for everything, including money. Even without Fed intervention, eventually rates would rise far enough that the demand for money at that price would diminish, and further debt-fueled growth would not be economical. The process is therefore somewhat self-correcting, although it normally overshoots in both directions before reversing. Periods of rising interest rates followed by periods of falling interest rates are a natural cycle. This cycle is either smoothed out or exacerbated, depending on your point of view, by the Fed’s interventions.
Whether the effects of rising rates turn out to be good or bad for the economy at large, the changes will definitely have an impact on all types of investments.
How Rising Rates Are Normally Expected to Affect Different Types of Investments
Stocks – positively at first, but ultimately negative if and when rates rise very high.
Bonds – Negatively for existing bond investments, as bond prices drop with rising rates. Positively for newly purchased bonds.
Precious metals – generally negative, unless the inflation rate exceeds short-term interest rates; then positive.
Oil and other commodities – mixed.
Note that each of the above asset types is affected by many things aside from interest rates, so it is never guaranteed that the tendencies shown will be determinative in a particular economic scenario.
Next time we’ll concentrate on how we can position our investments for the coming changes.
