Interest rates are one of the most talked about things in the world of finance.
We hear about them all the time, whether it’s on a financial news network or our bank statement.
The reason for this is that interest rates are one of the key factors in determining how the economy functions.
What are interest rates?
When you hear someone on the BBC talking about interest rates, the likelihood is they aren’t talking about the rate they get on their current account.
Instead, they’ll be talking about the interest rates that central banks set.
Almost every country in the world has a central bank. The UK’s central bank is the Bank of England and, in the US, it’s the Federal Reserve.
Central Banks have a few roles but the two main ones are to dictate monetary policy by controlling the supply of money and setting interest rates.
These rates are so important because they determine the rate at which other banks borrow from central banks.
Lower interest rates will be passed on to consumers, making it easier to borrow money. The reverse is also true. Higher central bank interest rates make it more expensive to borrow.
How will this affect my portfolio?
Changes in interest rates will impact different types of assets in different ways.
That means the composition of your portfolio will determine how interest rates impact your investments.
How do interest rates affect stock prices?
Lower interest rates generally lead to stock prices increasing. There are two main reasons for this.
Firstly, businesses can get cheaper access to credit because they can borrow at low interest. This means they can spend cash more freely and use it to grow.
As stock prices are strongly tied to company performance, a growing business is more likely to see its share price rise.
Another reason for growth in stock prices when interest rates are low is that, because it becomes easier to borrow money, there is more cash floating around in the economy and it's more likely that there will be higher levels of inflation.
These things contribute to higher stock prices as, if investors have access to more cash, they’ll be looking to do something with it. Investing in stocks is one of the things they’ll be likely to do if they want to growth their wealth.
Higher levels of inflation also encourage this process. That’s because buying stocks is a common way of shielding yourself against the negative impact that inflation has on your wealth.
Of course, the reverse of this is also true. If interest rates are higher, then stock prices tend to not increase as much because all of the trends mentioned above are reversed.
The stock market is, however, a diverse place, with lots of companies that are active in a range of sectors. That means interest rates will not have the same impact on every single company.
For example, banks might see their stock price rise in a higher interest environment as they stand to make more money from their lending services.
How do interest rates affect bond prices?
Bond prices tend to correlate strongly with interest rate changes.
In simple terms, lower interest rates will lead to higher bond prices but lower bond yields.
The reason for this is that, when interest rates fall, people start buying bonds as they look for safe assets that will pay them a higher rate of interest than leaving cash in the bank will.
This leads to an increase in demand for bonds, which then pushes their price higher.
As a result of this higher price, the return investors see on bonds — or ‘yield’ to use the right financial lingo — goes down.
Again, the reverse here is also true.
Higher interest rates will generally result in lower demand for bonds. That means the price of bonds will be lower but the yields on bonds will be higher.
How do interest rates affect real estate prices?
The main way in which interest rates will affect regular people when it comes to real estate is down to changes in mortgage rates.
Interest rates have some bearing on how mortgage rates are set. When mortgage rates go up, it becomes harder to borrow money and, consequently, harder to buy property.
This has positive and negative effects for both buyers and sellers.
As it becomes harder to get a mortgage, real estate owners may have to lower the amount they sell their property for, so that it becomes more affordable for potential buyers. The result of this is that it can be cheaper for you to buy a house when interest rates are higher.
The downside is that, because it is more expensive to borrow cash, then you may be unable or unwilling to take out a mortgage. If this happens then more people will want to rent houses, something that’s good for anyone that owns rental properties.