When the Federal Open Market Committee (FOMC), the arm of the Federal Reserve (or 'The Fed') that is ultimately responsible for deciding about interest rates, held its bi monthly meeting last week, it decided to postpone an increase in the interest rate. As commentators scrambled to dissect the Fed's comments, a glaring omission was noted: the word 'patient' was removed from the latest statement.
The eventual increase in interest rates in the US will probably be the most significant event in global finance in 2015. Interest rates hit record lows (currently 0.25%) following the financial crisis in 2008. The aim was to stimulate the economy by increasing the supply of money. Now the recovery is underway, the financial authorities feel the time is about right for an increase.
The more immersed you become in the world of finance, the more you start to appreciate the role played by the rate of interest. The price of money, as it is also known, is very apt.
Any increase in interest rates will inevitably influence the markets. So I've put together a summary of the impact interest rates can make on three of the most popular markets amongst traders: the stock market, currencies and bonds.
But first, let's briefly explore the role of interest rates in monetary policy.
Interest rate as a tool of monetary policy
Interest rates are predominantly employed to manage inflation, an increase in the price of goods; and deflation, which has the opposite effect. You might think that inflation sounds like a bad thing but sometimes economic conditions necessitate such a stimulus. Low inflation, which the US is currently experiencing, can lead to deflation where prices fall, output shrinks and unemployment increases. So a certain amount of inflation is normally favoured by most governments (the US, UK and Eurozone target roughly 2% per annum).
So how does the interest rate influence inflation? When the authorities lower the rate of interest, the cost of borrowing money falls. A lower interest rate means lower mortgage repayments, leaving people with more disposable income. A business can borrow at a cheaper rate, allowing it to invest in new technology or whatever else it needs to expand. The net effect is an increase in the flow of money which should boost prices. In times of excessive inflation, raising interest rates has the opposite effect by slowing down expenditure.
As briefly mentioned earlier, central banks are responsible for setting the interest rate. In the UK, the Monetary Policy Committee (NYSE:MPC) sets the official bank rate which is the rate of interest the central bank charges financial institutions for a loan with a maturity of 1 day. The US takes a slightly different approach. The FOMC sets a target federal funds rate, the rate at which financial institutions lend to each other overnight. It then uses what are known as open market operations- the purchase and sale of government bonds by the central bank- to keep the rate as close as possible to the target. Commercial banks use these rates to determine the interest rate they charge customers for loans such as mortgages.
Next, I will explore how interest rates influence the markets.
Influence of the interest rate on the markets
The conventional wisdom (pretty much the only kind of wisdom in the financial markets) is that low interest rates boost the stock market while high interest rates hurt it. As I described above, low interest rates increase the flow of money in the economy. Increased consumer spending translates to improved earnings. Equally, capital expenditure enhances output which should have a similar effect. Both of these scenarios make a company more appealing to investors, leading to an increase in its share price. Incidentally, the US indices rallied following the FOMC's announcement with the S&P 500 jumping 1.2%.
A high degree of correlation exists between inflation, interest rates and exchange rates. Interest rates increase when a country's economy faces inflation. High interest rates in turn attract foreign capital because the country's financial assets consequently generate a greater level of return. As you'll see below, higher interest rates mean higher yields on fixed income securities such as government bonds. What this generally means is a country's currency will strengthen as foreign investors essentially buy the native currency to hold its high yielding securities. For evidence of this effect, check out the EUR/USD charts from last week. The dollar experienced its worst day against the euro since 2009.
Fixed income securities come in a variety of flavours so to keep things simple, I'm going to focus on government bonds (known as treasuries in the US and gilts in the UK) and corporate bonds. Yields are currently low in line with interest rates. But an increase in interest rates has the inverse effect on the price of a bond. To put this in context, if you buy a ten year US treasury today, the yield is around 1.9%. If interest rates rise in 6 months, the yield on bonds issued subsequently will also be higher. The bond you bought today will then be worth less due to the smaller yield. Bond prices also rallied in response to the FOMC's statement as investors persevered in their hunt for yield in the immediate future.
Quantitative Easing (QE)
The problem with interest rates as a tool of monetary policy is they won't fall much lower than 0% (negative interest rates occur from time to time). So when inflation needs a further boost, quantitative easing is implemented. QE involves a central bank buying financial assets such as government bonds from commercial banks. Similar to lowering interest rates, the aim is to increase the supply of money to the economy by increasing a commercial bank's liquidity which theoretically trickles down to borrowers. The US and UK have previously implemented QE (in the case of the US, on several occasions) while the European Central Bank has just embarked on its first round of QE. Many economists remain unconvinced about the effectiveness of QE, not to mention the unforeseen longer term consequences although it has arguably boosted the US indices over the last few years.
Hopefully this article will help highlight the fundamental role that interest rates play in the markets. It was never my intention to put together a comprehensive guide (experts will note the omission of real and nominal rates for example), rather to come up with a simple overview of the interaction between interest rates and the most frequently traded financial assets.
As for when interest rates will rise and by how much, the general consensus is that an increase will take place in the US at some point this year in a small increment of about 0.25%. Keep a close eye on inflation (or indeed deflation) figures because the financial authorities will be reluctant to increase interest rates if prices continue to fall. Meanwhile, expect commentators to continue reading between the lines every time the FOMC issues a statement as they try to pre-empt the most powerful figures in the world of finance.
P.S. Blame my cynical nature but I can't help feeling that Janet Yellen, the Fed's chairwoman, enjoys teasing 'Fed- watchers'. A few days after the FOMC meeting, she came out with this gem:
"Just because we removed the word patient from the statement doesn't mean we are going to be impatient."