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Interest rate and inflation 101

Introduction

The rising cost of living, measured as inflation, affects our daily lives as much if not more than our investments do. As an important tool to stabilize inflation, interest rates have a profound impact on financial markets, determining the prices of different assets.

Interest rates and inflation are intimately related

Central banks adjust monetary policies to manage inflation

Have you thought about why prices rise over time? Think about the price of a movie 20 years ago versus today—that’s the power of inflation. But inflation isn’t all bad. Mild inflation helps boost the economy because if consumers expect prices to rise they are more likely to spend today to avoid higher prices tomorrow. More spending in turn encourages economic activity, creates employment and spurs investment. Conversely, in times of deflation, when prices are falling, consumers typically defer spending and economic growth suffers.

Interest rates represent the cost of borrowing and are closely related to inflation. To stabilize inflation, central banks tend to adjust interest rates from time to time to ensure the economy will not get overheated or shrink. If interest rates rise, which means the cost of borrowing goes up, consumers will be more inclined to save than spend. Companies will also slow their investments because borrowing to expand is more expensive. The decrease in demand will end up holding back economic growth and slow down inflation.

How do interest rates affect your investments?

The impact of interest rates on investments

Financial markets are very sensitive to interest rates. Bond prices, for instance, are inversely related to interest rate movements—when interest rates rise, bond prices fall and vice versa. Rising interest rates can also hurt equity prices because rising borrowing costs can weaken a company’s profitability. Rising rates can also make interest-bearing investments like GICs and bonds more attractive to investors compared to equities.

However, rising interest rates do not necessarily always hurt stock performance. During an 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 from making loans will likely increase. Rising interest rates also imply that the economy is expanding, economically cyclical stocks, such as those in the consumer discretionary and industrial sectors, will also benefit from stronger consumer confidence and domestic consumption.

Foreign exchange rates and 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 to be exchanged into the higher-rate local currency. This increased demand will strengthen the higher-rate local currency. In comparison, a currency with a lower interest rate will become less appealing as investors sell it to move into currencies with higher rates.

Yet interest rates are 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 minimize interest rate risks

Be prepared for interest rate risks

Interest rate changes not only bring challenges, but also investment opportunities. During an economic expansion, rate hikes might not be a bad thing because to a certain extent they reflect strong growth momentum, which is beneficial for financial markets and the economy. More significantly, investors should work with an advisor to assess their investment goals in relation to interest rate changes.

Bond investments are relatively sensitive to interest rate changes. In a rising interest rate environment, the coupon, or interest payment, that a bond pays can still offer a return to investors. But 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 interest rate changes. A bond’s duration is expressed as a number of years and it tells you how sensitive its price will be to changes in interest rates. A higher duration means greater price sensitivity because investors are less certain about the future cost of borrowing.

Diversification 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.

Disclaimer

Information provided on this page is for information purposes only and does not constitute any financial, legal, tax, investment, or other advice and should not be relied upon in that regard. Any graphs, charts, or graphics are used for illustrative purposes only and do not reflect any future event or future value or performance of any investment or investment strategy. Click to read more