Why interest rates matter

Over the last few years, financial headlines have been dominated by references to interest rates, as their direction and the speed at which they have moved have had an impact on investments across the board. Here’s some reasons why interest rates matter.

The most obvious is that clients can now earn more in cash assets than at any time since 2007. This provides choices regarding investments that have not been there during this time. The other side of that coin though is that borrowing costs are also higher. How higher rates impact you depends largely on whether you are a new saver or a net borrower; higher rates favor the savers over borrowers.

Central banks, through monetary policy, use interest rates as a tool to control inflation and stimulate or cool down economic activity. Changes in interest rates set by central banks can have cascading effects on the yields of government bonds. Government debt is considered a benchmark for risk-free assets, and its yields influence the pricing of other fixed-income securities (mortgages, for example). In the case of the last few years, the inflation that came out of Covid as well as the prior 15 years of low rates have been the targets of the Fed. By raising short term rates, the Fed can in theory slow certain areas of the market, with the most obvious ones being the labor market and the housing market. By trying to make supply greater than demand, the theory is that prices comedown.

Bonds are directly influenced by interest rates. The relationship between bond prices and interest rates is inversely proportional, meaning when interest rates rise, existing bond prices fall, as new bonds with higher yields become more attractive. Conversely, falling interest rates can result in higher bond prices. Bonds have long been considered among the more conservative investments for investors because they hold less risk than stock investments. However, in the last few years as rates have risen (and bond prices have fell), these bond investments have declined in price.

For stock investors, interest rates have a profound impact on equity (stock) valuations. When interest rates are low, the cost of borrowing decreases, making it cheaper for businesses to expand and consumers to spend. This often leads to increased corporate profits, driving stock prices higher. Conversely, rising interest rates can dampen economic activity as borrowing becomes more expensive, potentially slowing down corporate earnings and negatively affecting stock prices. Higher rates tend to hurt smaller or more aggressive growth companies more, since stock prices are discounted based on future earnings (which are presumably less with higher rates).

We’ve had an inverted yield curve for many months, which has been evident in the unusual phenomenon of (for example) shorter term CDs having higher rates than longer term CDs. An inverted yield curve, where short-term rates exceed long-term rates, has historically (but not always) been a precursor to economic recessions.

In a low-interest-rate environment like the one from 2008-2021, the search for yield may lead investors to explore alternative investments or dividend-paying stocks to enhance income. However, the higher returns come with increased risks, and careful due diligence is essential. As the risk-free rate on government bonds rises (as we have recently seen), investors once again have the opportunity to seek yield with less investment risk. This in turn can shift how clients see risk/reward and take appropriate actions.

Finally, rising rates have a larger impact on the economy as a whole, particularly since the U.S. has so much more debt than it has historically. Paying a higher rate on our debt increases debt service as a percentage of overall government spending, crowding out other areas unless our government has offsetting increases in revenue (potentially taxation). This is also something to consider when making decisions.