Have you ever wondered about the relationship between interest rate and stock markets? Take two minutes and make yourself comfortable: today, we will explain just that. Obviously, as always, in simple words.
When interest rates are low
In the phase of an economic cycle where interest rates are very low, many things happen simultaneously.
Borrowing money is cheaper
It is a great time to get out of debt. Those who have to buy a house apply for a mortgage, taking advantage of low rates; those who have to buy a new car choose to do so now by being able to take out a loan at lower rates. In summary, low rates support consumption, stimulating demand. Increasing the demand for goods and services increases industrial production; therefore, companies’ profits are projected upwards. Low-risk bond investments are not very profitable precisely because of low-interest rates, and consequently, the equity world is preferred, driven upwards by consumption growth. It looks like a toy land for an investor, but it can’t last forever. Do you know why?
Inflation starts to rise
The increase in demand for goods and services leads to a generalized price increase. The more a good is requested, the more its price increases. It is the oldest and best-known law on the market. A generalized increase in the prices of goods and services is called inflation, leading to a decrease in the purchasing power of money. For example, suppose yesterday I paid 10 euros to buy something and today to buy the same thing I paid 11. In that case, it means that the purchasing power of the currency has decreased by 10% and that the salary I receive today is worth less
How Do Governments Fight Inflation?
To mitigate the effect of inflation, Central Banks raise interest rates, thus starting the reverse process. People are beginning to borrow less because mortgages and loans now have more expensive installments; they have to spend more to pay off the interest on outstanding debts and consume less. Companies, therefore, sell less and lower estimates of future profits. Meanwhile, the rise in rates makes bond instruments more attractive.
Clearer ideas
We have learned an essential rule: when rates are low, the scenario is generally positive for the equity environment and less attractive for the bond world. But, conversely, in a context of high rates, it is exactly the opposite: the world of equities becomes less attractive, while the yield on bonds becomes attractive.
However, it is not that simple
Now that you understand this relationship between interest rates and financial markets, do you want to immediately run to invest? Hold back a moment: it’s not all that straightforward, especially for the following reasons:
- the different world economies are at the same time positioned on different levels of the economic cycle. For example, the US economic cycle is much more mature now than the European one. Moreover, the rate hike in the US has already started for some time. And since the economies of different states are, in any case, very interconnected with each other, these aspects must also be evaluated.
- While the real economy needs time for upward or downward movements in interest rates to take effect, the financial world usually anticipates these phenomena and reacts before they manifest. It even tries to understand, through the Central Banks’ statements, what the upcoming actions will be, trying to anticipate them.
- You may sometimes see market reactions that violate the newly learned rule. Let’s try to explain it to you with an example. If the market had bet on an imminent 0.50% hike in interest rates, but then the Central Bank had formalized a 0.25% hike, we will see a euphoric reaction from the stock markets, albeit in the presence of a rate hike… This is because stock prices had already incorrectly adjusted to an expected 0.50% increase in interest rates.
- Finally, the variable interest rates, although important, are not the only ones to influence the performance of the stock and bond financial markets. There are many other factors, especially of a geopolitical and demographic nature.
Conclusion
What lessons can we draw from what has been said so far? The most important lesson is that a good investment portfolio must include equities and bond instruments simultaneously to always have profitable instruments at any stage of the economic cycle. The dose of equity and bond will undoubtedly depend on the investor’s risk appetite and the time horizon, but it is good that the two components are both present. A good financial advisor will certainly be able to identify the right composition and instruments related to your specific investment objectives.
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