Rising interest rates are everywhere in the news lately. In the UK and over the world, rising rates put extra pressure on consumers, as the monthly cost of housing for both renters and homeowners is likely to rise as fixed rates of mortgages come to an end.
Interest rates also play a really important role in determining the performance of the overall stock market. This is a lesson that every finance student learns in their introductory University classes. It is important for us all to understand how this is likely to impact the overall stock market as we try to navigate uncertain times.
Let’s think about what an interest rate is first!
Interest rates are the rate at which banks lend money to one another and the rate at which consumers can borrow money from banks. When interest rates are high, borrowing money becomes more expensive, and consumers and businesses are less likely to take out loans. This can slow down economic growth, as businesses are less likely to invest in new projects and consumers are less likely to make big purchases. It has been argued by central bankers that this is necessary in order to curb inflation.
When interest rates are low, however, borrowing money becomes cheaper, and consumers and businesses are more likely to take out loans. This can lead to an increase in economic growth as businesses are more likely to invest in new projects, and consumers are more likely to make big purchases. This is what has been happening for a while in the developed world. Many governments were thankful for the low rates, especially during the pandemic when they had to borrow a lot to keep the economy afloat in the light of necessary lockdowns in order to keep people safe. However, rising rates were again inevitable and this is what we have been towards the end of 2022 and into 2023.
But how do rising interest rates impact the stock market?
The stock market is closely tied to the health of the macroeconomy and the macroeconomy ties closely to the microeconomy (businesses that trade and consumers!). When the economy is growing, companies are more likely to see increased profits, and they have more profitable projects, which can lead to a rise in stock prices, this is what we have seen running into the pandemic. However, when the economy is struggling, companies may see decreased profits and a decline in stock prices. Think about the large tech layoffs we have seen from the big technology companies (predominantly in the US).
When interest rates are low, it can signal that the central bank of the particular country (Bank of England in the UK, Federal Reserve in the USA, European Central bank in the EU) believes the economy is weak, and they may need some policy implications to stimulate growth. This can lead to a decrease in stock prices as investors become more cautious (and scared) about the state of the economy. We often understand financial markets to be closely related to how fearful investors are at a particular time. On the other hand, when interest rates are high, it can signal that the central banks believe the economy is strong, and that it’s time to slow down growth to prevent inflation. The age-old story is that we need higher rates in order to control inflation (some economists disagree with this, but it seems the state of play in the latest round of high inflation that we have seen in 2022/2023). This can lead to an increase in stock prices as investors become more confident in the state of the economy. However, this depends on a lot of other factors too. What we actually see in financial research, is that the sector or industry a company is in plays a really important role in whether inflation is likely to improve stock market returns or hurt them.
It is important to keep in mind that interest rates are just one of many factors (lots of macroeconomic variables are used to produce forecasts of the stock market) that can impact the stock market. Other factors such as company earnings, global events, and political developments can also have a really big impact. As we always say on our website. It’s ALWAYS a good idea to do your own research and consult with a financial advisor before making any investment decisions. As said in our about us page, we are here to increase your financial knowledge, nothing more and nothing less!
If you are feeling helpless, what can you do to combat rising rates and rising inflation?
The huge uncertainty of rising interest rates can be unsettling for anyone, but with the right strategy, you can prepare your finances for the potential impact of both inflation and interest rates. This is our guide on how to prepare.
First and foremost, it’s important to understand how interest rates can affect your finances. When interest rates rise, the cost of borrowing money increases. This can make it more expensive to take out a loan or credit card, and can also lead to higher interest payments on existing debt like car payments etc. So a great first step is to look at which debt you have and if is there anything you can do to help keep payments manageable. Additionally, rising interest rates can also affect the value of investments such as bonds, which can lead to a decrease in their value. So the next thing to do is to look at your investments. Are you heavily invested in industries that are likely to take a big hit due to rises in inflation and interest rates?
A big thing that you can do to prepare your finances for rising interest rates, is to reduce your existing debt! This means paying off high-interest credit card debt and making extra payments on any loans you may have. By reducing your debt, you’ll be in a better position to handle the increased cost of borrowing money.
Another great piece of advice to prepare your finances for rising interest rates is to diversify your investments. How can you do this? By investing in ETFs!!! This means not putting all of your money into one type of investment, such as bonds, which can be affected by rising interest rates. Instead, consider diversifying your portfolio by investing in a mix of stocks, bonds, and other types of investments. This can help to mitigate the impact of rising interest rates on your overall investment portfolio.
Finally, it would also be great to try and think about an emergency fund. Increasing your savings during times of turmoil can really help to navigate any periods of volatility. This means having a savings account that you can rely on in case of unexpected expenses or financial emergencies. This will ensure that you have a safety net in case rising interest rates make it more difficult to borrow money in the future.
Overall, interest rates play a significant role in determining the performance of the stock market. By understanding how these rates can affect economic growth, you can make more informed decisions about your future.
To gain key strategies and insights for successful investing, be sure to read our previous post on tech titans in Turmoil. Access it easily by following the link provided.