What are the effects of rising interest rates?

How do higher interest rates affect the economy?

Higher interest rates affect the economy in a number of ways: from curbing consumer spending and stalling business growth to determining the value of a country’s currency and the performance of financial markets.

A central bank, such as the Bank of England, will typically hike rates when inflation gets too high, making it more expensive for commercial banks to borrow money from it. Commercial banks, in turn, will shift this extra cost onto consumers and businesses, making borrowing money more expensive for them as well. This increased cost of credit generally dampens consumer confidence, leading to a reduction in spending on goods and services.

Interest rates can also affect the value of a country’s currency. When a country’s official interest rate is raised, its currency will appreciate. This is because the higher interest rate attracts investment from foreign savers, who live in countries where the rate of return is lower.

In turn, this situation creates an increase in the demand for, and the value of, that particular currency. Political and economic stability still have a greater bearing on a currency’s value than the interest rate in that country. Stock markets may also react to adjustments in interest rates, as investors factor in the effects of reduced borrowing and spending across the economy.

Trade on interest rates

The complex effects of rising interest rates can be illustrated as follows:

Why are interest rates changes important to traders and investors?

Changes in interest rates are important to traders and investors because they have a significant impact on financial markets – creating possible opportunities. Interest rate announcements made by major central banks – Bank of England (BoE), Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BoJ) – are particularly important in this regard.

The forex markets are often volatile in the period surrounding interest rate decisions. As mentioned earlier, when a country’s interest rate is raised, its currency more attractive to investors. This is because its currency is likely to appreciate against those used in countries where interest rates are lower. The converse also holds true.

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What happens to the markets when interest rates rise?

While interest rate increases have an impact on all financial markets, its effect is especially noticeable in the bonds and shares market.

What happens to bonds when interest rates rise?

The interest rate plays a significant role in determining the supply of and demand for bonds. It all comes down the ‘coupon rate’ of the bond: if the new interest rate is higher than the coupon rate, demand for bonds fall and if its lower than the coupon rate, demand increases.

To calculate the bond coupon rate, take the face value of a bond (eg £2000) and divide it by the annual coupon amount (eg £100). Then, calculate it as a percentage – ie (100 / 2000) x 100 = 5%. So, if the interest rate rises to 6%, demand for bonds will drop.

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What happens to stocks when interest rates rise?

The price of stocks can also fluctuate when interest rates are changed, as investors consider the potential effects on public companies’ revenues and adjust their portfolios. So, when there are interest rate announcements, you could take a long or short position on shares.

Check out this explanation on how interest rates affect the stock market

How interest rates affect spending

Rising interest rates affects spending because the cost of borrowing money goes up. So, if you have a mortgage, any type of credit card or a loan, you could end up paying more for the money you originally borrowed.

This will mean that you inevitably have less money to spend on goods and services. The opposite is also true – if interest rates fall, you’ll likely have more money in-pocket, which could increase spending. Rate hikes do, however, offer you an incentive to save more money, as you’ll receive a higher return on the cash you hold with a bank.

Interest rates and inflation

Interest rates and inflation are closely related. Since interest rates affect the cost of borrowing, and inflation affects the cost of saving, increasing one will result in a decrease in the other.

Central banks have the difficult task of striking a good balance between the two by keeping interest rates low to encourage consumer spending, while also keeping inflation in check to ensure that the prices of goods and services remain affordable. These monetary authorities often react to high inflation by raising interest rates.

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The effects of rising interest rates summed up

• Higher interest rates can curb consumer spending and stall business growth. It can also determine the value of a currency
• Changes in interest rates are important to traders and investors because it has a significant impact on financial markets, such as forex, shares, and indices
• The interest rate plays an especially significant role in determining the supply of and demand for bonds
• Rising interest rates affects spending because the cost of borrowing money goes up. It does, however, offer an incentive to save
• Since interest rates affect the cost of borrowing, and inflation affects the cost of saving, increasing one will result in a decrease in the other.
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