Keeping your goals on track with interest rates on the move
Interest rates have been on the move this week and that can impact your life through cost of living, cost of borrowing, and potential return on savings and investments.
This article covers what has been happening and what you need to be aware of.
We will commence with an explainer. In the European Union, the United Kingdom, United States, Australia and many other countries and regions, an independent central bank, that is independent from the government, meets to assess the economy and set the official interest rates.
Their objectives are specific to the country or region and broadly are to create a smooth economy, and to avoid the extremes of recession and inflation, although they will sometimes accept one as a cure for the other.
In the EU, the European Central Bank’s main objective is to keep inflation between 2-3% per annum. For the US Federal Reserve, it is achieving maximum employment while keeping inflation within an acceptable range.
For those interested in economics, this is called monetary policy.
Pre-Covid we enjoyed a long period of interest rate stability. The European Central Bank went 11 years (from 2011 to 2022) without raising interest rates. In this period they reduced rates a number of times and then we had unprecedented stability where rates didn’t change at all for 6 years. The markets, investors, and many people day to day became used to this predictability and calm environment. It was a good time to borrow money, because interest rates were very low, but not such a good period to have cash in savings accounts with interest rates at or around zero.
Nothing stays the same forever though. In a sequence, the extraordinary impact of the Covid pandemic on global economies meant that Central banks and governments pumped large amounts of money into the economy. The inevitable outcome of lots more money in the economy, besides addressing the immediate need of keeping the economy going, is inflation. And that is what happened. The graph below shows the arc of inflation in the last 10 years and that huge Covid hangover spike. After such a period of very low inflation and stable interest rates this was a shock to many.
Once inflation soared, central banks responded by raising interest rates. By making money more expensive via high interest rates, it helped to reduce spending and thereby reduce inflation. Now that inflation is deemed to be back under control central banks are once again lowering interest rates. See below the European Central Bank interest rates over the last 5 years.
To show it was not just Europe, the US interest rate movements are show here below as well following a similar path:
What is the relevance of this and how does it affect your investments and your life?
These changes can impact you in several parts of your life.
The first is inflation – as inflation is now back in the 2 -3% pa range, we should start to see a slow down in the rate at which prices are going up. In the last couple of years, you probably noticed the cost of your grocery bill rising quickly. This should slow again. Prices will still go up, but not as quickly. In short, good news.
Your mortgage. The cost of your mortgage, and for new buyers, the amount you can borrow, is influenced by interest rates. If interest rates are falling and they are expected to fall for a period of time, the cost of borrowing will become progressively cheaper (all other things being equal, or ‘ceteris paribus’ as economists like to say when they are trying to sound clever). If you have a mortgage with a variable interest rate, your repayments may reduce as the interest rate goes down. If you have a fixed rate, you will not have to worry about these changes. As interest rates move, it can be a good time to speak with your mortgage broker to work out the optimal time to move from variable to fixed, or when to renew a maturing fixed interest rate.
Bank interest rates. Whatever is good for mortgages is generally bad for savings accounts, and vice versa. With falling interest rates, term deposits at banks, and at call interest rates, will reduce. If you have a maturing term deposit it will be important to assess the newly offered rate before making a decision. We can help you with this assessment.
Your investments. If you have investments, the impacts are more complex. First you should consider time. If you have a long-term focus, you may not- and probably should not- need to make short term reactive changes. Focus your long term portfolio positioning with your long term goals.
What will change though?
When interest rates are higher and reducing, as we are starting to see now, it is usually a stronger time for defensive assets like government and corporate bonds (also called fixed interest). This underpins the importance of a diversified portfolio.
What about stocks? We can say with confidence, and have repeated this often, that we are certain we do not know what will happen in the market tomorrow. Therefore, portfolio construction is based on long term expectations, your goals, and the knowledge that growth assets like stocks, go up over time, but not in a straight line. The detailed market analysts might suggest we will see a continuation of the rotation we have observed in recent months towards defensive stocks. That is because defensive stocks tend to pay a dividend income. As the interest rates reduce, the income (called a coupon) that newly issued bonds will pay will be lower and at some point the dividend income will be more attractive than the coupon income. This sometimes pushes share prices up.
Our advice therefore, when it comes to managing these components is to have a diversified portfolio that reflects your risk profile, your goals and your time horizon. That means that what is right for one person may not be right for the person next door.
The second point is to get good advice from an independent regulated professional.
You can contact us at info@blackswancapital.eu and we can discuss the impacts of the movements through the economic cycle on your investments and your life, and what you can do about them.
