What are interest rates? How does the change in the interest rate affect our investments in the stock market? What factors influence interest rates so that central banks determine some rates or others? We’ll tell you in this article.
What are interest rates?
The interest rate is neither more nor less than the price of borrowing money. If we use the example of Spain, the ECB (European Central Bank), the central bank in charge of setting interest rates in our country, sets an interest rate that can be higher or lower depending on the period in which the borrowed money must be repaid.
High-interest rates impact companies’ financing since credits become more expensive since investments are less profitable for companies, affecting their income statement.
If interest rates are very low (such as between 2015 and 2021), there may be a risk that companies will borrow excessively and, given a future rise in interest rates, have financial problems.
Therefore, we must find stability for interest rates that, although it is difficult to specify, if can be, better below that average level.
Who sets interest rates?
Interest rates are set by the central banks that have the greatest influence on the economy:
- FED in the United States.
- ECB (European Central Bank) in Europe.
- Central Banks of England, Japan, Switzerland, New Zealand, Australia, Canada or Poland, among others, are also highly relevant.
One of the most consulted sections of our stock market guide for beginners is the impact that rate hikes have on the stock market.
What factors influence the rises and falls in interest rates?
There are several, but two macroeconomic factors are most relevant in determining a rise or fall in the interest rate: inflation and the evolution of the exchange rate.
Inflation is the most decisive variable in the evolution of the interest rate. Remuneration must be valued in real terms.
If inflation increases in a country or economic zone, it is most likely that the country or zone will have to raise the nominal interest rate to maintain its actual return on money.
To defend the exchange rate, central banks increase the interest rate, which can cause significant economic stagnation that can cause greater mistrust in international markets.
This often happens with emerging countries and influences the markets due to the interest rate in the face of a weak currency and its influence on economic growth.
Other less relevant factors in exchange rates: employment and economic growth
Other influencing factors are employment (job creation is less significant) and economic growth (income), but they will only have an influence when it affects inflation.
The international environment is also an important factor due to the globalisation of the interest rate market.
How does the interest rate affect the stock market?
And it is that interest rates are known as the price of money, but in reality, it is also the price of time. And it is normal when money is more expensive to obtain or to finance a project. They tend to value more projects with close returns, since it is challenging to obtain new liquid capital.
And vice versa, if it is very cheap to raise new capital, then the money is valued less, which is why it is usually invested in longer-term projects.
The truth is that since the Great Financial Crisis of 2008, the Central Banks of various countries, particularly the FED and the ECB, opted for low-interest rates and even zero to stimulate constant investment in very long-term projects, which gave rise to very high PER ratios.
What happens if interest rates fall? Which sectors benefit?
As we have already commented, interest rates are the price of money but also of time, valuing very long-term projects more due to the ease of obtaining new money with very cheap loans.
As with the 10-year German bond in 2021, it became negatively profitable. Because the German State managed or protected your capital, you had to pay a kind of “premium” – the negative interest rate.
While on the variable income side, everything is jubilation and happiness. As it is easy to obtain new money, investors do not mind betting on long-term projects -even if they sometimes do not make sense, so the stock market tends to rise strongly.
In this scenario, the technological and renewable energy sectors, that is, projects that, even though they have an idea of where they want to go, are still investigating how it can be done, are the ones with the best performance. usually offer.
However, in this type of scenario, caution must be exercised, as it sometimes happens that investment fever is so high that it leads to financial bubbles and inflation. This fact forces central banks to raise interest rates to contract the economy and reduce price escalation. And then what happens?
What happens if interest rates rise? Which sectors benefit?
If interest rates rise, investors will find the stock market less attractive since other markets, such as the fixed-income market and bank deposits, will provide them with more significant benefits without risk. Therefore, the fixed income will increase concerning investment in the stock market.
Therefore, concerning equities, although there is general regret in the markets, especially in those projects with a very long-term vision, it will be the sectors that work with solid projects and with very immediate returns that serve as a refuge for investors. investors.
For example, the food, infrastructure, and pharmaceutical sectors tend to withstand widespread falls that may occur in the stock market. This seems logical since even if it is expensive (or very expensive) to get money for new investment projects, we will all need to continue eating and moving around the cities. We will want to be taken care of in case our health relapses.
These companies, which, no matter how bad the macroeconomic situation is, usually hold up well and sometimes even improve their results, are also called blue chips.
In conclusion, interest rates are mainly affected by:
- Evolution of inflation in developed countries.
- The behaviour of the currency in emerging countries.
- Evolution of interest rates at the international level due to the possible contagion effect from other countries.
And if rates rise, equities will be more affected, to the benefit of fixed income. While if the rates fall, it will be the other way around. Investors will value the variable income sectors more compared to fixed income ones.