What has been happening with interest rates?
An interest rate, put simply, is the price of borrowing money. Interest rates can appear in several formats (mortgage rates, credit card rates etc.) but at its most fundamental, it represents a percentage of the loan amount that a borrower agrees to pay, over a certain period, for the privilege of using a lender’s funds. For lenders, on the other hand, the interest rate is a form of compensation. It’s not just a return on their investment, but also a means to offset the risks associated with lending, such as the possibility of the borrower defaulting or the potential loss of purchasing power due to inflation.
Interest rates in the UK have been rising steadily in 2023 and reached their highest level since the global financial crisis in 2007-08.
In the UK, the year 2023 has seen a steady climb in interest rates, due to a conscious move by the Bank of England to try and tame the beast of inflation. The fundamental premise is simple: inflation rears its head when the economy’s demand for products and services overshadows their supply. The weapon of choice to fight inflation often is an increase in interest rates. This approach has a dual effect, firstly, borrowers find their resources dwindling as the costs of borrowing escalates, and secondly, the Bank Rate or the interest rate that banks charge each other for overnight loans goes up, for example, the LIBOR rate surged from 0.1% in December 2021 to 5% in June 2023, reaching its peak since 2007. This trickles through to rates that consumers can get by keeping their money in the bank, and therefore the demand for goods and services further reduces.
There are several factors that have contributed to the rise in interest rates in the UK, similar stories can be made for other countries around the world. One is the war in Ukraine, which has caused energy prices to rise sharply. This has put upward pressure on inflation, as businesses have passed on higher energy costs to consumers.
Another factor is the UK’s own economic recovery. The economy has grown strongly in recent months, and unemployment is at a record low. This has put upward pressure on wages, which has also contributed to inflation. Strikes have also been having an impact on putting pressure on employers to raise wages, which some would argue can contribute to even more inflation.
“Bank of England Governor Andrew Bailey and U.K. Finance Minister Jeremy Hunt warned that high wage settlements are making it more difficult to contain inflation”.
The Bank of England’s prognosis points towards a continued escalation of interest rates in the foreseeable future. This move, though necessary to rein in inflation, could potentially amplify the cost of borrowing for businesses and consumers and thus, impede economic growth.
Which variables had an impact on the 2023 surge in UK Interest Rates?
- The global stage has had its part to play, with the war in Ukraine setting off a chain reaction of soaring energy prices.
- The UK’s internal narrative also contributes, with its resurgent economic recovery exerting an upward pressure on wages.
It is important to note that interest rates are not the only factor that affects inflation. Other factors, such as supply chain disruptions and government policies, can also play a role. However, interest rates are a key tool that the Bank of England can use to manage inflation.
What is the current state of interest rates around the world?
The current state of global interest rates shows varying dynamics influenced by a combination of factors such as inflation rates, economic growth, and policy stances of central banks. Some of the highlights (using data from https://www.worldbank.org/en/home and https://www.imf.org/en/Home) include:
- Argentina maintains the highest central bank interest rate at 97.00%, a move likely designed to combat its high inflation rate from 2017 to 2021, which averaged 40.85% during this time.
- Japan is currently the only country with a negative interest rate (-0.10%), a measure implemented in 2016 to spur inflation and economic growth.
- In the United States, the central bank’s interest rate stands at 5.25%, resulting in a real interest rate of 2.79% after considering the average inflation rate from 2017 to 2021.
- The European Union’s Eurozone has set its central bank interest rate at 4.00%, however, the average inflation rate was not available in the data provided.
- Zimbabwe displays the highest inflation rate (183.31%) compared to its interest rate of 150.00%, leading to a negative real interest rate (-33.31%).
- On the other end of the spectrum, countries such as Australia (4.10%), Canada (4.75%), and the United Kingdom (5.00%) have managed to maintain relatively moderate central bank interest rates compared to their average inflation rates over the past few years.
These fluctuations across the globe reflect the varying economic circumstances and policy approaches of each country or currency union. As an investor, understanding these dynamics can be crucial for formulating strategies, especially when considering international investments.
How can investors protect themselves against rising rates?
A key story in interest rate rises is the price of bonds, when interest rates rise, bond prices fall, particularly those who expire later, what people in finance call ‘having a longer maturity’. Shifting portfolios away from short-term bonds is a way to mitigate risks.
There are also investment opportunities with a built-in inflation ‘armour’, and while every investment carries its own risks, historical patterns reveal certain types that fare better during inflationary times. Dividend-paying stocks, and sometimes real estate (subject to various factors), have proven to be resilient against inflationary storms.
In this ever-evolving financial landscape, one contender for investor attention stands out: the Vanguard Value ETF (VTV). This ETF finds its north star in the performance of the CRSP US Large Cap Value Index, a financial map directing us towards a plethora of larger companies currently trading at an appealing discount.
In this game of risk and reward, VTV tends to lend itself to periods of high inflation. Is less sensitive to the changes of interest rates than other investment, particularly those growth-oriented ETFs. When interest rates decide to climb up the economic ladder, the value of growth stocks often tumbles down, a casualty of shrinking discounted future earnings – a core reliance for these companies.
Analysts, those financial fortune tellers, look forward into a company’s future earnings and compare it to a discount rate. This rate is tied with a Gordian knot to the interest rate. As interest rates ascend, they demand a higher toll from investors – a compensation for the additional risk. This tollgate often repels interest from investors, making growth stocks lose their sparkle and their prices to wane.
Therefore, the Vanguard Value ETF (VTV) presents itself as a poised shield bearer for investors against the sharp teeth of rising rates, standing firm amidst the storm.
It is always important to speak to qualified professional before making investment decisions.