Interest rate and inflation basics

Interest rates and inflation are intimately related

Central banks adjust monetary policies to condition inflation levels

Have you thought about why a bowl of wonton noodles see such different prices between now and 40 years ago? That is the power of inflation. When the general price level rises persistently, the purchasing power of a currency falls. Mild inflation is conducive to economic development because consumers, expecting prices to continue to rise, prefer buying now than later to avoid the erosion of their purchasing power. Greater spending in turn encourages economic activities, creates employment and spurs investment. On the contrary, in times of deflation, consumers expect prices to fall and therefore defer spending.

Interest rate is the cost of borrowing. It is closely related to inflation. To stabilise inflation, central banks tend to adjust interest rates from time to time to ensure the economy will not get overheated or shrink. If interest rate rises, meaning the cost of borrowing goes up, consumers will be more inclined to save than spend. Companies will also slow their investments. The decrease in demand will end up holding back economic growth and slow down inflation.

How do interest rates affect your investment?

Why do you need to learn about the impact of interest rates on investment?

The financial market is very sensitive to interest rates. Bond prices, for instance, are negatively related to interest rate movements (i.e. when interest rate rises, bond price falls). However, not all bonds are sensitive to interest rates the same way. Meanwhile, in a rising interest rate environment, equities will also be affected because rising borrowing costs weakens a company’s profitability and lowers investors’ risk appetite.

That said, rising interest rates does not necessarily hurt stock performance. During economic boom, financial services stocks – which are relatively sensitive to interest rates – tend to perform well. Banking stocks in particular take advantage of rising interest rates as their interest income will likely increase. Rising interest rates also implies that the economy is expanding, cyclical stocks such as those in the consumer discretionary and industrial sectors will also benefit from stronger consumer confidence and domestic consumption.

Forex strength a function of interest rate movements

High interest rates attract inflows, and vice versa

Interest rate movements also affect the valuation of a currency. If a central bank hikes rates, the local currency will become more attractive due to its higher interest return. That will naturally attract more foreign currency being exchanged into the local currency and strengthen the latter. In comparison, other currencies with lower interest rates will become less appealing due to the lower interest return. Investors might also sell the currency, causing it to fall. The greenback, for instance, normally strengthens against other currencies as a result of US interest rate rise.

Yet interest rate is just one of the many factors that affect the foreign exchange markets. Geopolitics, economic stability and trade conditions also play important roles.

Do your homework to minimise interest rate risks

Put up the umbrella to fend off interest rate risks

Interest rate changes not only bring challenges, but also investment opportunities. Investors should always pay attention to how interest rates are developing and find out the drivers behind those trends. During economic expansion, rate hikes might not be a bad thing because to a certain extent it reflects strong growth momentum, which is beneficial to the financial market. More significantly, investors should always assess their investment goals in order to adapt to interest rate changes.

Bond investments are relatively sensitive to interest rate changes. In a rising interest rate environment, the coupon that a bond pays can still bring return to investors. As mentioned previously, not all bonds are sensitive to interest rates the same way. For instance, the longer a bond’s duration is, the more sensitive the bond’s price is to the interest rate changes.

Diversification always helps lower investment risks regardless of any interest rate movements. A balanced portfolio with both equities and bonds is therefore more effective in withstanding market volatility.