How rising rates impact investments
This is the fifth and final in a series of articles to mark Financial Literacy Month.
Inflation is insidious. It decreases monetary value, purchasing power, slows spending, raises costs, all with various impacts, deleterious or beneficial on households, industries, capital markets, and governments.
How is inflation controlled?
The US Federal Reserve, along with other country central banks, is regulator of an economy whose role is to provide stability, smooth out (so-to-speak) interest rates, prices, and consistent employment. Currently, their work is cut out for them as according to varying financial gurus and statistical evidence, inflation in the US is the highest in 40 years.
The Fed uses numerous monetary tools: open market operations (OMO), the federal funds rate (FFR) and the discount rate (interest rates) to maintain this equanimity.
OMO is the Fed process of buying from, and selling to, its member banks, generally, trading in US Treasury notes to free up capital for expansionary supply, or to tighten the capital now available.
FFR is the Fed interest rate that banks charge each other for overnight loans, differentiated from the discount rate set by the Fed to allow banks to borrow from the Fed to manage their reserve requirements.
The Fed changes in monetary and credit policy to cause these institutions, in turn, to pass the increase (or decrease) impact on to all types of consumers, service, and product producers.
The impact: money and credit was cheap, now it has become much less so.
Impact of rising rates on bonds
Bonds, generally a fixed-income debt security, can be sovereign, government agency, corporate, etc.
Interest rate fluctuations, even minute movements, cause bond volatility across the global bond-trading platforms – which are five to seven times larger than equity markets.
Why? There is an inverse relationship between the price of a bond and interest rates.
When a bond or note is first issued into capital markets – let’s say four years ago (2018), it is denoted at par face value, that is 100 per cent – for example, a $1,000 bond price.
It is also given a fixed interest rate (coupon) that carries and is paid throughout the life of the bond to its maturity date, say ten years. At a pure issue, the interest rate and the bond yield are the same. The 2018 interest rate remains at 2 per cent, annually, no matter what the interest rates are in the economy, moving up or down.
Most importantly, at maturity a bond investor will receive his or her $1,000 value amount back, assuming the bond is high credit quality.
Currently, interest rates across the capital market environments are going up. That means new 2022 bond issuances will pay a much better interest rate, for example, 3 per cent or more. Investors will want the new 2022 bond, not the old one at 2 per cent interest and may sell it off, taking a loss.
Why would anyone want a 2018 low interest rate bond in a high interest rate environment? The bond price is discounted below $1,000 (100 per cent), say to only $800, a bargain; this pricing compensates for lower interest rate, but how?
The pay-off at maturity!
The investor purchasing the 2018 bond still receives the 2 per cent interest rate for the life of the bond and at maturity, receives 100 per cent face value, $1,000, even though he or she paid only $800. This profit of $200 is a very simple example for explaining yield – the interaction of a current bond price and its fixed (coupon) interest rate.
Impact on stocks
Publicly traded stocks from micro to massive companies of all forms are impacted negatively or positively, but require a different perspective than bonds.
Stocks represent the valuation of companies in open markets and are subject to many influences, among them: higher cost of debt particularly with variable interest rates, consumer trends and demand, growth appreciation prospects, obsolescence, production supply chains, future earnings, and competition from offerings such as new certificates of deposit – with higher interest rates and less volatility.
Various investment websites note that financial stocks may do well given that the underlying companies can raise credit/lending interest rates, while others have stated that stock investing should focus on entity fundamentals.
Ultimately, management of debt will delineate the successful company and its share value from its peers. A further article on this is coming soon.
Impact on commodities
Commodities are one of the investment major asset classes, such as:
•Wheat, corn, soybeans, or other bulk foods
•Cattle or other livestock
•Domestic and foreign currencies
•Coal, oil, and other fossil fuels
Commodity prices and interest rates have an inverse relationship, all predicated on the cost of carrying inventory: high interest rate, lower commodity price, as producers will only buy on an as-needed-basis and reverse. The cost to procure and/or short supplies – in the ongoing invasion of Ukraine environment – changes pricing unpredictably as well and is reflected in the share price of companies in the commodities industry.
Impact on crypto
Higher interest rates generally mean a lower appetite for high-risk/high-return assets such as cryptocurrencies, so that market should brace for a parallel increase in risk aversion, according to CryptoVantage’s Simon Chandler.
Impact on personal households
According to Investopedia: “When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.”
Households still have to pay for healthcare, food, housing, insurance, transportation, communication and more. Wages very often do not rise in tandem with inflation, so common-sense households cut back spending by reducing demand for goods and services; such actions impact business’s cash flows to bottom line profits, producing a trickle-down effect on stock valuations.
Readers, this is financial literacy in action.
Financial literacy wellness is a very important component of understanding and paying attention to the big world picture. What happens out there ultimately impacts us.
It's not just about managing your personal finances better. The best outcome is a fundamental success because you are able to anticipate future financial impacts, giving you far more control of your personal finances.
How the Federal Reserve Controls Inflation: The Way the Fed Uses Its Tools to Manage Prices, Kimberly Amadeo, thebalance.com
How Do Interest Rates Affect the Stock Market? By Mary Hall and Somer Anderson, Investopedia
Higher Interest Rates and Commodity Prices, Andrew Hecht and Michael J Boyle, The Balance
• Martha Harris Myron JSM is a native Bermudian with US connections. She is an Amazon / Apple published author of The Dawn of New Beginnings: A Back-2-Basics Financial Review to Dramatically Improve Your Lifestyle – Book One of The Bermuda Islander Financial Planning Primers Series and a Google News Contributor.