Cracking the Code: Interest Rates and Financial Markets
The ordinary man on the street knows interest rates from their loans and savings. When you owe the bank money, you repay the loan with interest. When you save money in a deposit account, the bank also rewards you with interest. These pertain to consumer interest rates, however, and if you're interested in trading and investing, you're more concerned about market interest rates.
Market rates directly and indirectly affect financial markets, which is why a global macro analysis undertaken by a market analyst cannot be complete without considering interest rates. In this article, market interest rates take the spotlight, along with a discussion on how they are determined and why they should matter to you.
Understanding Market Interest Rates
Market interest rates are the cost of borrowing funds in the open market, reflecting the price borrowers pay to lenders for the use of capital. Interest is justified by the following:
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Cost of Foregoing Other Investments: When someone lends money, they forgo investing that amount elsewhere. Lending money, therefore, comes with opportunity costs associated with alternative investment options not taken.
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Cost of Deferring Consumption: Money on hand now is better than money forthcoming in the future. However, by lending their money, lenders defer using that money now and, thus, forgo the satisfaction that consumption would have given them.
Both factors justify the levying of interest or why it costs money to borrow money.
How are interest rates set? They are determined through the interplay of several factors, including:
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Risk-free return to capital: This is the return you will get if you invest in a risk-free instrument like government securities. It serves as the baseline for determining other interest rates.
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Inflationary expectations: Lending means taking on the risk of inflation; if you don't earn interest greater than inflation, you'll lose money. Lenders anticipate future inflation and adjust interest rates to ensure their returns are not eroded by rising prices. Therefore, interest rates are higher when there's high inflation or rising inflation is anticipated.
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Risk premium: This accounts for the possibility that a borrower may default. Riskier investments command higher interest rates to compensate lenders for taking on the risk of default.
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Liquidity premium: Investments that are not readily convertible to cash carry a liquidity premium. Lenders require a higher rate of interest for less liquid assets because they need compensation for the cost and time they may have to spend to liquidate such assets.
Accounting for these factors, the nominal interest rate on a given investment is expressed as:
Nominal interest rate = Risk-free return to capital + Inflationary expectations + Risk premium + Liquidity premium.
Traders and investors need to understand these drivers, so they can anticipate if interest rates will rise or fall and, thus, adjust their trading and investing strategy accordingly.
How Interest Rates Affect Financial Markets
Any changes in market interest rates have long-reaching and widespread impacts on stock, bond, currency, and commodity markets.
Stock Markets
Higher interest rates mean borrowing money is more expensive. Consequently, companies with debt experience reduced profits and falling stock prices. Growth stocks, which rely on future earnings, are hit particularly hard. For example, the Nasdaq Composite fell by over 30% in 2022, primarily due to rising interest rates.
Bond Markets
When interest rates increase, newly issued bonds represent higher yields than older bonds, which were launched when interest rates were lower. These newer bonds are, thus, more attractive than older bonds.
Those invested in older bonds face an opportunity cost for having their funds tied up in low-yield instruments. This induces them to sell off their bond holdings so they can reinvest in newer bonds with better yields.
This was, in a way, what spurred the great bond selloff of 2023. Major central banks, such as the U.S. Federal Reserve and the Bank of Canada, signalled a shift towards tighter monetary policies to curb uncontrolled inflation. Since tighter monetary policies mean rate hikes and the impending fall of bond prices, investors tried leaping ahead of the curve by selling off their bonds.
Currencies
Higher interest rates attract foreign investments. Foreign investors looking for better yields may invest in a country's bonds and other interest-bearing products (e.g., deposits) to realise gains from the higher rates.
This influx of capital increases demand for the country's currency, leading to currency appreciation and strengthening its value relative to other currencies (currencies trade in pairs, so relative value is significant).
Even before the inflow of foreign investments is realised, the anticipation of it can lead to currency market activities aligned with a stronger currency, i.e., foreign currency traders buying the country's currency in anticipation of its value increasing.
A stronger currency, however, has a dampening effect on the export market. If it takes more of another currency to buy a country's currency, fewer foreign importers can afford the country's exports. Conversely, the country's importers benefit because their money can buy more imports from abroad.
Commodities
Rising interest rates usually hurt commodities. Specifically, they can lead to a demand slowdown.
First, when interest rates are high, traders become more circumspect about buying commodities on borrowed funds. This depresses demands.
General consumer spending may also decrease. People may travel less to save money. The curbing of expenditure affects the demand for related commodities. For instance, a cutback on travel expenditures can lead to a reduced demand for energy commodities.
Additionally, commodities do not pay dividends or interest. When interest rates rise, holding on to commodities incurs a greater opportunity cost; bonds look attractive because of their higher yields. Storage costs may also increase, compounding the cost of commodities trading and investing.
Trading With Confidence
Interest rates directly and indirectly affect financial markets. They're something your online broker religiously tracks.
If you want to succeed in trading and investing, you ought to pay attention to them, too.
About The Author
Contact Dylan Bailey privately here. Or send an email with ATTN: Dylan Bailey as the subject to contact@investorshangout.com.
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