An introduction to interest rates and how they can affect investments.
What are interest rates?
The interest rate is the amount a borrower pays for borrowing money from a lender, which is why it's often referred to as the cost of borrowing.
Conversely, the interest rate is also the amount earned on money deposited into a bank or financial institution, also known as the rate of return.
Why is the cash rate so important and how does it influence interest rates?
The interest rate a bank charges borrowers is influenced by the cash rate, which is set by the Reserve Bank of Australia (RBA).
The cash rate is the interest rate on unsecured overnight loans between banks, and is an important part of a central bank's monetary policy which is why it receives so much attention.
The primary objective of the RBA's monetary policy is to encourage strong and sustainable economic growth. One way to do this is by using the cash rate to influence interest rates, which in turn influences economic activity by changing the incentives for households and businesses to save or consume and invest.
So, an increase in the target cash rate will generally mean an increase in the interest rates charged by banks and financial institutions if passed on.
Higher interest rates make the cost of borrowing more expensive while also encouraging households to save more. This usually reduces spending and consumption, placing less demand on goods and services, which reduces upward price pressures and ultimately helps to control inflation.
How can rising interest rates affect investments?
When it comes to investing, interest rates affect different investments in different ways.
Bonds have an inverse relationship to interest rates. When interest rates go up, bond prices tend to fall. This is because new bonds issued at the higher interest rate will generate higher returns, so there's less demand for existing bonds at the lower rate. The opposite happens when interest rates go down.
Interest rates can also affect the share market indirectly. As rising interest rates make the cost of borrowing (and therefore the cost of doing business) more expensive, company revenue may be negatively impacted as liabilities increase, leading potentially to less growth and lower market valuations.
Property investments can also be affected by rising interest rates as mortgage repayments become more expensive, which in turn reduces the incentive for investors to borrow money to invest in property.
What should investors do when interest rates increase?
Rising interest rates can be cause for concern for some investors, particularly existing bond investors who may be witnessing fluctuations in their portfolios.
It's worth noting that there can be a lot of noise and chatter surrounding bonds during periods of changing rates, but Vanguard research has shown that rising rates can be a good thing for bond investors if their investment horizon is long enough. Bonds should also be considered for their portfolio diversification benefits, not just for the returns they generate.
It's also a timely reminder that markets are forward looking and have already priced in future return expectations. Investors should be similarly forward-looking and focus on the long-term, which includes making sure they are diversified across different asset classes and sticking to their chosen asset allocation despite volatility in the short-term.