Interest rates and inflation are intimately related

Central banks adjust monetary policies to condition inflation levels

Have you thought about why a bowl of wonton noodles see such different prices between now and 40 years ago? That is the power of inflation. When the general price level rises persistently, the purchasing power of a currency falls. Mild inflation is conducive to economic development because consumers, expecting prices to continue to rise, prefer buying now than later to avoid the erosion of their purchasing power. Greater spending in turn encourages economic activities, creates employment and spurs investment. On the contrary, in times of deflation, consumers expect prices to fall and therefore defer spending.

Interest rate is the cost of borrowing. It is closely related to inflation. To stabilise inflation, central banks tend to adjust interest rates from time to time to ensure the economy will not get overheated or shrink. If interest rate rises, meaning the cost of borrowing goes up, consumers will be more inclined to save than spend. Companies will also slow their investments. The decrease in demand will end up holding back economic growth and slow down inflation.

How do interest rates affect your investment?

Why do you need to learn about the impact of interest rates on investment?

Investing in an inflationary and rate-rising environment

The financial market is very sensitive to interest rates. For example, in general, bond prices are negatively related to interest rate movements. When interest rate rises, bond price will fall. However, different bonds have different degrees of sensitivity to interest rate changes:

The shorter the duration of the bond, the less sensitive it is to interest rates, and the more resilient it is against the impact of rate hikes

There is a type of bond known as floating-rate bond. Its coupon rate is linked to a specific market interest rate, and hence, it will benefit if the interest rate rises. It is considered an investment tool that is resilient to rate hikes

Many investors have some experience with inflation-linked bonds. The coupon rate of such bonds is usually linked with the issuer’s (for example, local governments) indicator of inflation, which means, under an inflationary environment (usually coupled with rate hikes), investors will enjoy higher interest income

During rate hikes, equities will also be affected. From the economic perspective, when borrowing costs rise, a company’s profitability will be weakened. On the other hand, from the perspective of stocks evaluation, when interest rates rise, the discount rate (the rate used to determine the present value of future cash flows) will also rise, and hence, there will be a downward adjustment in the valuation of growth stocks. However, rising interest rates may not affect the performance of all types of stocks:

During economic boom, financial services stocks, which are relatively sensitive to interest rates, tend to perform well during rate hikes. For example, banking stocks are likely to take advantage of increasing interest rate spread, and hence, benefiting from rate hikes

When rising interest rates are triggered by inflation, cyclical stocks such as those in the resources and energy sectors usually benefit from rising commodity prices and will outperform the market

Forex strength a function of 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 being exchanged into the local currency and strengthen the latter. In comparison, other currencies with lower interest rates will become less appealing due to the lower interest return. Investors might also sell the currency, causing it to fall. The greenback, for instance, normally strengthens against other currencies as a result of US interest rate rise.

Yet interest rate is 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 minimise interest rate risks

Put up the umbrella to fend off interest rate risks

Interest rate changes not only bring challenges, but also investment opportunities. Investors should always pay attention to how interest rates are developing and find out the drivers behind those trends. During economic expansion, rate hikes might not be a bad thing because to a certain extent it reflects strong growth momentum, which is beneficial to the financial market. More significantly, investors should always assess their investment goals in order to adapt to interest rate changes.

Bond investments are relatively sensitive to interest rate changes. In a rising interest rate environment, the coupon that a bond pays can still bring return to investors. As mentioned previously, 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 the interest rate changes.

Diversification always 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.