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When a central government changes their base interest rate, the effects can be seen throughout the wider economy in both the short and long term. This is because a changing interest rate affects not only how much someone receives for saving money, but also how much someone would be charged for borrowing. It affects individuals, businesses, and governments. A minor change can affect everything from international FX rates, to mortgage repayments, discretionary consumer spending, bonds and money markets, and even a broad range of commodities.
This change to the interest rate essentially changes the velocity of money within the domestic and international market, changes the supply and demand of goods and services, as well as the expected future value of appreciating assets and securities. This change to the wider economy can also provide traders with market movement and therefore opportunity to speculate.
The basic principle behind changing interest rates and the velocity of money
When you have a low interest rate, people are less inclined to save, and borrowing money can be cheap. Instead of saving and waiting to purchase something, why not just do it now? As an individual, you can buy that car or house now, or as a business you can borrow money to build that new shop, hire additional staff, or get new equipment.
When the rate at which money changes hands increase, i.e. the velocity of money increases, this generally has a knock-on effect for productivity and job creation, inflation and output. For example, say the interest rate is low and I can borrow money to build a house, I would then go on to pay builders, suppliers, logistic companies, and insurers etc. These companies, broadly speaking across potentially millions of new customers, have an increase in revenue and can employ additional staff and pay better bonuses.
The company itself can also borrow to buy new tools and equipment to increase productivity and help their staff. These staff in turn can then go on a holiday they may not have been able to afford otherwise, buy a new car, or simply start having a coffee on the way to work. Effectively, the increase in the wider economies liquid cash reserves increases spending speed, and drives growth.
Although the ‘trickle down’ economics argument is hotly disputed for the super-rich, it’s generally accepted that, for the common man, the above is true. It’s fair to say that the opposite can also be true. When interest rates rise the cost to borrow will rise. Maybe the original person won’t be able to build a house as big, or the construction worker has their man hours reduced by 10% and can’t go on his original holiday, or buy that coffee. If you apply this logic to business and governments alike, you can start to see how interest rates affect all aspects of the market.
The key point here is that all these markets are interconnected. When you’re looking for trade opportunities, have a think about what the effect of a higher rate to borrow might have, and factor that into any trade decision.
Markets to watch on the back of changing interest rates
The international FX markets are, as usual, the first to be affected with changing interest rates. If one country offers a better rate of interest for having my savings parked there, why don’t I just easily move my cash over? The reality is more complicated than that, but at a surface level this selling of one currency and buying of another (all other things being equal) is the most likely outcome of a change to interest rates.
Stock markets and bonds are also likely to be affected, as investors chase the highest rate of return on their investment. This is especially true for dividend paying blue chip stocks, not only because of that rate of return, but because of the change to business and consumer psychology. Higher interest rates generally mean less borrowing, less opportunity for quick growth, reduced revenue, and potentially reduced earnings and dividends.
Bonds, on the other hand, have an inverse relationship to interest rates, so when interest rates rise, bonds generally fall. This is because when interest rates are low, it’s easier to borrow money, and many companies will finance bonds to fuel expansion.
Commodities, especially if the asset is quoted in USD and the Federal Reserve (Fed) make an interest rate change, are likely to be affected. If a commodity costs $1000, for example, and the underlying USD value (when compared to other currencies) changes, then the demand for that asset is likely to fluctuate as well.
So are changing interest rates a big deal?
The long and short of it is that a change in interest rates has the potential to affect a large number of different markets. A change in interest rates fundamentally changes the very top level supply and demand of money itself, and therefore a large number of other assets, liabilities, securities, and money markets within an economy. We will be exploring this more in-depth over the coming weeks, with a series surrounding “how interest rates affect…”
Let us know on IG Community if there are any areas you would specifically like us to focus on and we’ll try and prioritise these areas of interest.