Interest rates have been raised 12 times in 13 months until June this year from 0.1%, where they have now been frozen for the 4th straight month at 4.1%. In some cases, high interest rates can be a sign of a healthy economy, however, the word high is subject to the environment. In other circumstances, the raising of interest rates can be a form of monetary policy to combat inflation.
A quick refresher
Interest rates are the cost of borrowing or the return on investment for lending or saving money. They are expressed as a percentage and are usually set by central banks (in Australia’s case, the Reserve Bank of Australia), financial institutions, or the open market.
They are important economic indicators and central banks use them to manage monetary policy and control inflation, changes in interest rates usually signal the health and direction of the economy.
Types of interest rates:
There are numerous form that interest rates come in, but some of the most important ones are;
Cash rate: The equivalent to the federal funds rate in the US, is the internet rate at which the RBA, our central bank, lends or borrows money to and from the banking system. This has several effects on the general public. When the RBA makes the decision to lower the cash rate on the first Tuesday of every month, commercial banks are more likely to reduce their own interest rates, making borrowing cheaper.
Mortgage Rate: Changes in the cash rate lead to changes in mortgage interest rates. When the rba lowers the cash rate, it makes it cheaper for banks to borrow funds, in turn passing down lower mortgage rates.
Exchange rate: A higher cash rate can attract foreign investment and strengthen the Australian dollar. Of particular note is the rise in Chinese property investment in Australia increasing by 30% from 2022 to 2023.
What’s the relationship between interest rates and investing?
An Inverse relationship exists here. When interest rates rise, stock prices tend to fall and vice versa. This is based on the idea that higher interest rates can make fixed income investments like bonds and savings accounts more attractive compared to stocks.
When interest rates rise, the discount rate used to value future earnings from stocks increases, which can lead to a lower present value for those earnings. When interest rates fall, the discount rate decreases, potentially resulting in higher present values for future earnings and potentially higher stock prices.
Economic health plays a part in the relationship between stock prices and interest rates, raising interest rates can come about due to strong economic growth and low unemployment, supporting corporate earnings and stock prices. However, interest rates can rise due to concerns about inflation or a central bank’s attempt to cool down an economy. It can negatively affect stock prices as it leads to higher borrowing costs for businesses and consumers.
Sector specific threats can impact the stock market and interest rates, too. Sectors like utilities and real estate may be negatively affected by rising rates because they carry higher levels of debt and are sensitive to borrowing costs. The financial sector can benefit from rising rates as they can earn higher profits from lending at higher rates.
What are the investing strategies in a changing interest rate environment?
Investors can use information about interest rates to apply it back to their thesis and age and stage of life. Risk tolerance is a big factor here, whereby a young investor may allocate a portion of their portfolio towards growth stocks when interest rates are low.
Diversification remains crucial regardless of the economic happenings in order to not get your portfolio damaged if a downturn of some sort happens in one sector/location.
Investors can consider bonds, short term or long term depending on what their risk tolerance is.
Investors can use the information to also inform real returns, if inflation is up and interest rates are up, investors may need to consider shifting portfolio weighting and relate it again back to their risk tolerance to inform the right decision.
What happens when interest rates are poorly managed?
In the early 2000s, low interest rates led to a surge in demand for housing after economic challenges including the bursting of the dotcom bubble. Mortgage rates were at a historic low, making houses very affordable and this fuelled a housing boom. Lenders relaxed lending standards and offered subprime mortgages to borrowers with weaker credit profiles. These mortgages often had adjustable interest rates that started low but later reset to much higher levels.
Hyperinflation can also occur. Below are two brief summaries many will be familiar with.
Zimbabwe (2000s)
- Economic mismanagement
- Land reform policies
- Political instability
- People resorted to using foreign currencies for transactions.
Weimar Republic Germany 1920s
- After world war 1
- Reparations payments, war debt
- They printed excessive amounts of money to service the debt
- Prices began to double every few days
- Central bank used interest rates to combat it but it had little effect. New currency got introduced called the Rentenmark to stabilise.
What are the risks and opportunities that come about with changing interest rates?
Low interest rates can inflate asset prices, leading to bubbles in housing, stocks or other asset classes, when these bubbles burst, it can result in financial instability and economic downturns. Often, malinvestment occurs, where resources are allocated to unproductive or inefficient projects because the cost of borrowing is so cheap, and this can result in a misallocation of capital and potentially reduce long term economic growth. Low interest rates can also discourage savings as the returns on savings accounts and conservative investments are minimal.
In a period of high interest rates, one of the most notable impacts is the servicing burden on businesses with variable rate debt. high mortgage rates can make ownership less affordable, leading to a slowdown in the market and declining home prices. Investors may adjust their portfolios in response to changing economic conditions. This can lead to sharp declines in stock prices.
What about right now?
History has shown that interest rates typically move quite gradually, whether that be up or down. With that being said, it will likely be a while before the cash rate is down to a point where it is not imposing a significant pressure on the cost of living. It is all down to the RBA’s monthly meeting on the first Tuesday of each month.
Keep Investing
Remember, at the end of the day this shouldn’t affect the ability to invest. Even with a changing thesis or tightening tolerance for risk, it has been shown time and again over the course of history that the stock market always bounces back. Even after the most significant downturns such as the GFC, in which the cash rate in Australia reached a high of 7.25% 👀
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