Analyst Insight
Introduction
Interest rate hikes are meant to help curb inflation, which may have a material impact on your investment portfolio. But first, let’s discuss why central banks use interest rates to help attain their respective objectives. For the Bank of Jamaica (BOJ), their objectives are the maintenance of price stability and financial system stability. The Federal Reserve (the Fed) has a dual mandate: pursuing the economic goals of maximum employment and price stability. To maintain or attain their respective objectives, central banks do this by adjusting short-term interest rates. if economic growth is lagging and unemployment is rising, the central banks can lower interest rates to make it cheaper to borrow. The reasoning behind this is to encourage businesses to invest in projects and hire employees to fulfill projects, which in turn should increase consumer income and spending. On the other hand, when the economy is growing too quickly, central banks may become concerned with inflation or other issues and would therefore lend help to an overheating economy. In this case, central banks can raise interest rates causing businesses to borrow and invest less due to higher than anticipated borrowing costs, thereby reducing hiring and consumer spending. Given the recent hikes in interest rates both locally and globally, it’s important to understand how it can affect the components of your investment portfolio.
Interest rate impact on bonds
Interest rates and bond prices have an inverse relationship, this means that when interest rates rise, bond prices fall and vice versa. Looking at a scenario where you purchased a bond for $100 or par value. If the central bank raises rates, this may decrease your bonds market value to $90. In this case, your unrealized loss is $10 but this is only realized if you choose to sell it. If you hold this bond to maturity, you should receive 100% of its original par value. When interest rate fluctuate, the market rate of a bond changes along with. But not all bonds are affected equally. Bonds with a shorter tenor may be less affected by interest rate changes, while longer maturity bonds may be more affected. Importantly, short-term interest rate movements should not affect the long-term outlook of an investor with a balanced portfolio. A decrease in bond prices today will likely be offset by a bond price increase at a later date which is why we encourage investors to stay the course despite current market volatility.
Interest rate impacts on stocks
Unlike bonds, interest rates do not directly affect the stock market. However, the central bank’s actions may have an indirect ripple effect on stock prices. For instance, when the central bank increases its rates, consequently banks raise rates for business and consumer loans. The idea is that borrowing costs increase so consumer spending decrease. People and businesses are less inclined to borrow, if they borrow less money, they spend less. While a rate hike might not affect the “BUSINESS” negatively, however, in a country like the US, a rate hike is going to bring about a more bearish sentiment towards stocks investors believe would be either directly or indirectly affected.
Interest rate impact on Real Estate
For real estate, an interest rate hike can hurt the market while a cut can be beneficial. Real estate loses its attractiveness in a rising rate environment from the perspective of the buyer, the cost to build has increased. In addition, real estate prices are closely linked to the interest rate market, due mainly to the cost of financing (mortgage rates) as well as some bond-like characteristics where investors get regular income payments. Similar to bonds, the steady stream of income generated by real estate becomes less attractive as interest rates and coupons on newly issued bonds rise.
There’s a lot of uncertainty right now due to geopolitical tension in Europe, rising fuel prices, supply chain issues from Covid-19 variants, and trillions of dollars pumped into the economy over the past two years. While the markets will very likely recover, timing the bottom or predicting how long it’ll take is anyone’s guess. Keep in mind that historically, investments have easily outpaced inflation even with the normal ups and downs of the market. It’s important to stick to your long-term investing plan as the best performing portfolios are generally the ones that have the most time in the market.
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Written by Jonathan Cook, Investment Strategy Analyst |
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