Global Financial Markets & Interest Rates

Each currency carries an interest rate. It is like a barometer of the strength or weakness of an economy. If a country’s economy strengthens, the prices may sometime rise due to the fact that the consumers become able to pay more. This may sometimes result in a situation where more money is spent for roughly the same goods. This can increase the price of the goods.

When inflation goes uncontrolled, the money’s buying power decreases, and the price of ordinary items may rise to unbelievably high levels. To stop this imminent danger, the central bank usually raises the interest rates.

When the interest rate is increased, it makes the borrowed money more expensive. This, in turn, demotivates the consumers from buying new products and incurring additional debts. It also discourages the companies from expansion. The companies that do business on credit have to pay interest, and hence they do not spend too much in expansion.

The higher rates will gradually slow the economies down, until a point of saturation will come where the Central Bank will have to lower the interest rates. This reduction in rates is aimed at encouraging the economic growth and expansion.

When the interest rate is high, foreign investors desire to invest in that economy to earn more in returns. Consequently, the demand for that currency increases as more investors invest there.

Countries offering the highest RoI by offering high interest rates tend to attract heavy foreign investments. When a country’s stock exchange is doing well and offer a good interest rate, the foreign investors are encouraged to invest capital in that country. This again increases the demand for the country’s currency, and value of the currency rises.

In fact, it is not just the interest rate that is important. The direction of movement of the interest rate is a good pointer of demand of the currency.

The interest rate that impacts the stock market is the central funds rate. The central funds rate is the interest rate that depository institutions banks, savings and loans, and credit unions charge each other for overnight loans (whereas the discount rate is the interest rate that Central Reserve Banks charge when they make collateralized loans usually overnight to depository institutions).

The influences the central funds rate in order to control inflation. By increasing the central funds rate, the Central Reserve is effectively attempting to shrink the supply of money available for making purchases. This, in turn, makes money more expensive to obtain. Conversely, when the Central Reserve decreases the central funds rate, it increases the money supply. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns.

When the Central Reserve acts to increase the discount rate, it immediately elevates short-term borrowing costs for financial institutions. This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy.

Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So, individuals’ consumers are impacted through increases to their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.

Consumers still have to pay their bills. When those bills become more expensive, households are left with less disposable income. When consumers have less discretionary spending money, businesses’ revenues and profits decrease.

So, as you can see, as rates rise, businesses are not only impacted by higher borrowing costs, but they are also exposed to the adverse effects of flagging consumer demand. Both of these factors can weigh on earnings and stock prices.

When Interest Rates Fall

When the economy is slowing, the Central Reserve cuts the central funds rate to stimulate financial activity. A decrease in interest rates by the Central Reserve has the opposite effect of a rate hike. Investors and economists alike view lower interest rates as catalysts for growth a benefit to personal and corporate borrowing. This, in turn, leads to greater profits and a robust economy.

Consumers will spend more, with the lower interest rates making them feel that, perhaps, they can finally afford to buy that new house or send their kids to a private school. Businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential. This, in turn, leads to higher stock prices.

Particular winners of lower central funds rates are dividend-paying sectors, such as utilities and real estate investment trusts (REITs). Additionally, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing.

Shifts in Demand and Supply in Financial Markets

Those who supply financial capital face two broad decisions: how much to save, and how to divide up their savings among different forms of financial assets. We will discuss each of these in turn.

Participants in financial markets must decide when they prefer to consume goods: now or in the future. Economists call this intertemporal decision making because it involves decisions across time. Unlike a decision about what to buy from the grocery store, decisions about investment or saving are made across a period of time, sometimes a long period.

Most workers save for retirement because their income in the present is greater than their needs, while the opposite will be true once they retire. So they save today and supply financial markets. If their income increases, they save more. If their perceived situation in the future changes, they change the amount of their saving. For example, there is some evidence that Social Security, the program that workers pay into in order to qualify for government checks after retirement, has tended to reduce the quantity of financial capital that workers save. If this is true, Social Security has shifted the supply of financial capital at any interest rate to the left.

By contrast, many college students need money today when their income is low (or nonexistent) to pay their college expenses. As a result, they borrow today and demand from financial markets. Once they graduate and become employed, they will pay back the loans. Individuals borrow money to purchase homes or cars. A business seeks financial investment so that it has the funds to build a factory or invest in a research and development project that will not pay off for five years, ten years, or even more. So when consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right.

For example, in the technology boom of the late 1990s, many businesses became extremely confident that investments in new technology would have a high rate of return, and their demand for financial capital shifted to the right. Conversely, during the Great Recession of 2008 and 2009, their demand for financial capital at any given interest rate shifted to the left.