Interest rate changes have far-reaching effects across various markets, including bonds, stocks, forex, commodities, and more. This post delves into the essentials of interest rates, covering key concepts such as:

• What is An Interest Rate? Interest is the cost of borrowing money, and the most important type of interest rates is the policy rate set by central banks.

• The Role of Central Banks and Policy Rates. Central banks use the policy rate as a critical tool to balance inflation and employment. A rate hike (a hawkish stance) slows economic growth and lowers inflation. Conversely,a rate cut (a dovish stance) stimulates economic growth and boosts employment.

• How Policy Rate Changes Affect Financial Markets?. In theory, a rate hike leads to higher yields for bonds, currency appreciation, and increased commodity prices, but the stock market may decline. However, in practice, the market changes are affected by various factors, including economic data, geopolitical developments, and overall market sentiment, which can make market movements less predictable.

Why Interest Rate Cut/Hike?

What Is an Interest Rate?

Interest is the cost of borrowing money, like the cost for buying food and drinks. An interest rate is expressed as a percentage of that a lender of capital charges on the borrower’s debt repayment, usually paid out over a specified period. Lenders can include banks, financial institutions, or individual lenders. Conversely, banks also pay interest to customers for depositing funds. Interest rates can vary across institutions, but the most important rate is set by the central bank, influencing all other rates in an economy. 

What Is a Central Bank?

Central banks are the institutions that are responsible for managing the monetary system for a nation or a group of nations. Their primary roles include formulating monetary policy, controlling inflation, maintaining employment levels, and ensuring currency stability. Most economies have their own central bank, and the ones most closely watched by global investors are:

• US Federal Reserve Bank

• European Central Bank

• Bank of England

• Bank of Japan

• Swiss National Bank

• Bank of Canada

• Reserve Bank of Australia

• Reserve Bank of New Zealand

Central Bank’s Policy Rate and Its Impact on Commercial Banks

The interest rate set by central banks is usually called the policy rate (also referred to as the benchmark or base rate). This is the rate at which the central bank lends money to the commercial banks or pays them for deposit. Commercial banks use the policy rate as the baseline to set their interest rates for loans (e.g., mortgages, business or personal loans) and saving products (e.g., deposit accounts). They usually charge borrowers a higher interest rate than the policy rate, to cover costs including administrative expenses, risks, profit margins.

In general, the central bank’s policy rate and commercial banks’ interest rate are positively correlated. When the central bank raises the policy rate, the cost of borrowing money for commercial banks increases, leading to higher interest rates on loans for consumers and businesses. Similarly, banks are incentivized to raise interest rates for savings to attract deposits.

For simplicity, the interest rate refers to central banks’ policy rate unless otherwise specified.

Why Does a Central Bank Change Interest Rates?

Central banks are responsible for maintaining a balance between a too fast growing economy and a too slow growing economy. If the economy grows too quickly, the resulting rapid inflation will make prices unaffordable for consumers. Conversely, if the economy grows too slowly, the unemployment rate will rise. The main mechanism they have to keep this balance in check is the interest rate.

• Rate hikes: Slow down economic growth, reducing inflation but potentially increasing the unemployment rate. 

• Rate cuts: Stimulate faster economic growth, lowering unemployment rate but potentially leading to rapid inflation.

Before delving into how interest rates work, let’s clarify some core concepts:

• Economic growth: Economic growth refers to the increase of goods and services in an economy over a period of time, typically measured by Gross Domestic Product (GDP). The GDP growth is driven by consumer spending (e.g., buying houses, buying cars) and business investment.

• Inflation: Inflation is a steady increase in prices of goods and services. Typically, inflation happens when demand exceeds supply. In a fast-growing economy, consumers and businesses demand goods and services more than business can afford. When demand exceeds supply, businesses struggle to meet the demand, and respond by raising prices of goods and services.

• Unemployment Rate: Unemployment rate is the percentage of people in the labor force who are unemployed. In a slow-growing economy, businesses may reduce their workforce to cut costs, increasing unemployment rate.

How Do Interest Rates Work?

Interest rates work by either encouraging saving or spending.

Interest Rate Cut

Interest rate cuts typically make borrowing money cheaper, which can encourage both consumer spending and business investment. For consumers, it means lower interest rates on mortgages, car loans and credit cards, making it more affordable to borrow and spend. On the other hand, by lowering reward for saving, interest rate cuts encourage spending instead of saving. For businesses, it means lower borrowing costs for businesses, enabling expansion and hiring. 

Overall, with more access to cash and relatively minimal reward for savings, businesses and consumers are encouraged to spend and invest. Spending and investment are the key factors for economic growth. As a result, by lowering interest rates, central banks can speed economic growth and combat low unemployment levels.

Interest Rate Hike

An interest rate hike will encourage commercial banks to hold on to their money. This is because they can earn a good return by keeping it with the central bank. Since the cost of borrowing money from the central bank increases, they will in turn charge higher interest rates on loans.

This can slow consumer spending and business investment, cooling down an overheated economy. Higher rates incentivize saving, as banks offer better returns on deposits. The decrease in spending and investment lead to a decrease in demand for goods and services, which in turn drives down their price. This helps reduce inflation but may also lead to higher unemployment as businesses cut back on expansion.

How Investors Anticipate and React to Rate Changes?

Interest rate changes are announced following central bank meetings, which occur regularly. For example, the Federal Open Market Committee (FOMC) meets eight times a year to discuss monetary policy for the Federal Reserve. Investors pay closer attention to these meetings, anticipating rate hikes, cuts, monetary measures like quantitative easing.

However, investors don’t wait for official announcements to take a position. They monitor various economic indicators that influence central banks' decisions and try to predict future rate moves. They also analyze central bank leadership to determine if key decision-makers are "hawks" or "doves."  

• Hawks favor higher interest rates to fight inflation.

• Doves prefer lower interest rates to promote economic growth.

A central bank as a whole may be described as hawkish or dovish, depending on their prevailing policy.

Takeaway

Interest rates represent the costs of borrowing money, with the most significant being the policy rate set by the central banks. The policy rate is a crucial tool for balancing low inflation and high employment. When central banks raise the policy rate (a hawkish stance), it slows economic growth and lowers inflation. Conversely, when central banks lower the policy rate (a dovish stance), it stimulates economic growth and boosts employment.

Typically, global investors try to predict future rate moves and adjust their positions accordingly. As a result, the financial markets often react to the investors’ expectations even before the policy rate change is officially announced.

How Interest Rates Affect Financial Markets?

Interest rate changes affect not only the growth of an economy but also various financial markets. To understand the relationship between interest rates and market fluctuations, we’ll consider the Federal Reserve’s rate hike in September 2022. On September 21, 2022, the Federal Reserve raised its policy rate by 0.75 percentage points to address persistent inflation. This decision had ripple effects across various financial markets.

Interest-Bearing Assets: Bonds

An interest-bearing asset is a financial instrument that generates income for the holder in the form of interest payments. Bonds, for example, are typically issued with interest rates that are competitive with the current market interest rates. The term "yield" refers to the return on a bond. Bonds can be traded in the secondary market, where their prices fluctuate based on supply and demand.

New Bonds Rates and Policy Rates

The interest rate of newly issued bonds usually positively correlates with the policy rate. When the policy rate increases, newly issued bonds must offer higher interest rates to attract investors. For example, after the Federal Reserve's rate hike on September 21, 2022, the yield on U.S. 10-year Treasuries increased.

Conversely, when central banks cut policy rates, the interest rates on newly issued bonds typically decrease. Lower policy rates reduce the yield that bond issuers need to offer to attract investors. However, this relationship is influenced by investor expectations about future inflation. If investors anticipate that a lower policy rate could lead to higher inflation, bond issuers might still offer competitive rates to compensate for this risk. 

Existing Bonds Prices and Policy Rates

The relation between policy rates and bond prices in the secondary market is reversed. When the policy rate rises, the prices of existing bonds generally fall. This is because the interest payment of the older bonds become less attractive, since the newer bonds offer higher rates. As a result, bondholders may have to sell their bonds at a discount.

Conversely, when the policy rate is lowered, the prices of the existing bonds tend to rise. This is because the interest payments become more valuable in a lower-rate environment, making these older bonds more attractive to investors. Consequently, bondholders can sell them at higher prices.

Forex

Exchange rates are influenced by demand and supply of currencies. 

The Impact of Rate Hikes on Currency

When interest rates increase in one country, that currency often appreciates because higher rates provide better returns on savings, bonds, and other interest-bearing assets, which attract investors to buy that currency for investment. Global investors tend to borrow money from a lower-rate economy to invest in a higher-rate economy. As a result, capital flows from lower-rate environments, increasing demand for the stronger currency.

For instance, following the Federal Reserve's rate hike on September 21, 2022, U.S. interest-bearing assets offered higher returns, attracting global investors to the dollar. This demand led to U.S. dollar appreciation, leading to the decline of the EUR/USD exchange rate. In other words, the stronger U.S. dollar meant fewer dollars were required to purchase the same amount of euros. The chart below shows that the EUR/USD rate dropped shortly before and after the Fed rate hike on September 21, 2022.

The Impact of Rate Cuts on Currency

A policy rate cut generally leads to currency depreciation as lower rates reduce the return on interest-bearing assets, prompting investors to seek higher returns elsewhere. This can lead to capital outflows and weakening of the currency. However, in some cases, a rate cut may stimulate economic growth, which could mitigate or even reverse the currency’s initial depreciation.

Commodities

The Impact of Rate Hikes on Commodities

Policy rate hikes also influence commodity prices, especially those denominated in a country’s currency. When a nation raises its policy rate, its currency often appreciates. As a result, commodities priced in that currency become more expensive for foreign buyers, leading to lower demand and falling prices of the commodities.

For instance, when the Fed raised interest rates on September 21, 2022, the U.S. dollar strengthened, making gold priced in the U.S. dollars more expensive for global investors. This resulted in lower demand and falling prices of gold. The following chart shows the gold price dropped shortly before and after September 21, 2022.

The Impact of Rate Cuts on Commodities

When a central bank cuts its policy rate, the opposite effect often occurs compared to rate hikes. A rate cut typically leads to the depreciation of the nation’s currency, as lower rates make interest-bearing assets less attractive to investors. In turn, a weaker currency makes commodities priced in that currency cheaper for foreign buyers, potentially increasing demand and driving up prices.

Stocks

The Impact of Rate Hikes on Stocks

When interest rates rise, it becomes more expensive and difficult for a company to borrow money from banks, which increases the debts and harms its ability to raise funds. If a company has trouble in raising capital, its short-term earnings and prospects will be negatively affected. More debt and less profit will lead to the decrease in the company’s share price. If the stock prices of an enormous number of companies decrease, many vital indices, like The Standard and Poor's 500 (S&P 500), will go down, resulting in a downturn in the whole stock market.

For instance, shortly before and after September 21, 2022, S&P 500 prices dropped in response to the fed rate hike, reflecting market concerns over the rising cost of borrowing and its impact on corporate profitability.

The Impact of Rate Cuts on Stocks

When central banks cut policy rates, the impact on the stock market can be complex but is often positive in the short to medium term. Lower interest rates reduce the cost of borrowing for companies, making it easier and cheaper to finance operations, expand, and invest in growth opportunities. This can improve corporate earnings and lead to higher stock prices.

Additionally, lower rates can shift investor preference from bonds and other fixed-income investments toward equities, as returns on safer assets decline. This influx of capital into the stock market can further drive up stock prices.

However, if the rate cut is seen as a response to weakening economic conditions, the stock market's initial boost may be tempered by concerns about the overall health of the economy. In cases where rate cuts are aimed at combating recessionary pressures, stock prices could remain volatile, as the benefits of lower borrowing costs are weighed against the risks of slower growth.

Cryptocurrencies

Cryptocurrencies are generally considered as high-risk assets. When central banks raise interest rates, the cost of borrowing increases, and riskier assets like cryptocurrencies tend to become less attractive to investors. Higher interest rates encourage safer investments, such as bonds or high-interest savings accounts, reducing the appeal of speculative investments like cryptocurrencies.

Conversely, when central banks cut interest rates, borrowing becomes cheaper, and investors are often more willing to take on higher risks for the potential of higher returns. This can drive demand for cryptocurrencies, pushing their prices higher.

Additionally, cryptocurrencies are often priced in U.S. dollars, so changes in the Federal Reserve's policy rate can influence the value of the dollar. A rate hike tends to strengthen the dollar, making cryptocurrencies more expensive to purchase for investors using other currencies. This can reduce demand and put downward pressure on prices.

Conversely, when interest rates are cut, the dollar may weaken, making cryptocurrencies relatively cheaper for foreign investors, which can boost demand and push prices higher.

Cheatsheet

Beyond Interest Rate

The analysis above specifically focuses on the effect of interest rate changes on financial markets, deliberately excluding other events that can also influence market movements. It is important to remember that these additional events—such as economic indicators  (e.g., inflation, employment, GDP), geopolitical developments, and market sentiment—play a crucial role in shaping market trends. This complexity is what makes market analysis both challenging and engaging. 

Let’s explain by examining the relationship between the U.S. dollar index and the policy rate hikes. The U.S. dollar index measures the value of the United States dollar relative to a basket of forex currencies, including the Euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona. When the dollar strengthens, this index rises. Conversely, if the dollar weakens, this index declines. Theoretically, when the Fed raises its policy rate, the U.S. dollar will strengthen, leading to a rise of the U.S. dollar index. 

However, in late 2022, even though the Fed had aggressively raised interest rates throughout 2022 to combat inflation, the U.S. dollar index declined after the U.S. consumer price index (CPI) report was released. 

Excluding volatile food and energy prices, the so-called core CPI in November, 2022 rose 0.2% on the month and 6% on an annual basis, below respectively expectations of 0.3% and 6.1%. The index signaled that inflation was cooling, and that the Fed might slow the pace of rate hikes. This caused expectations of future rate hikes to be tempered, which weakened the dollar as it reduced the appeal of holding USD-denominated assets.

In this case, investors’ expectations of future money policy affects the value of the U.S. dollar, despite the fed rate hike.

To make informed investment decisions, it is essential to stay updated not only on central banks’ policy rate change but also on these broader factors.

Conclusion

Interest rate changes are a powerful tool used by central banks to influence economic conditions, influencing financial markets as well. Rate hikes can slow down economic growth by making borrowing more expensive, which can lead to new higher bond yields, stronger currencies, lower stock prices, as well as reduced commodity and cryptocurrency prices. Conversely, rate cuts aim to stimulate economic growth by making borrowing cheaper, often resulting in new lower bond yields, weaker currencies, higher stock prices, and increased commodity prices. Additionally, lower rates can boost interest in higher-risk assets like cryptocurrencies. Understanding these dynamics is crucial for investors, as interest rate decisions interact with a variety of economic factors and market conditions. Always consider the broader economic context when analyzing market movements related to interest rate changes.

As the Federal Reserve rate cut in September 2024 is imminent, investors should prepare for potential market impacts. Lower borrowing costs can boost economic activity, likely driving stock prices higher, particularly in technology and consumer discretionary sectors. Bonds may experience price increases and yield declines, while the U.S. dollars might weaken. Commodities like gold could rise as a hedge against inflation. It’s important to diversify portfolios and remain aware of external factors, such as inflation and geopolitical risks, which can influence market behavior beyond the rate cut itself.