How do interest rates impact financial markets?

federal reserve stamp
Rebecca Cattlin
By :  ,  Former Senior Financial Writer

What is an interest rate?

An interest rate is the cost of borrowing money. It is expressed as a percentage of the total loan – whether that’s cash, goods or property. It is also the amount earned on deposits in a savings account.

When you borrow money, you’ll pay back the original amount – the principal – plus the interest. This means the money repaid is greater than the amount borrowed.

Who sets interest rates?

Interest rates are set by a country’s central bank.

For example, in the UK, interest rates are based on the Bank of England base rate. By increasing and decreasing the rates at which high street banks can borrow money from the BoE, the institution can influence the rates that are passed on to consumers and businesses.

Banks and building societies will set individual interest rates on loans based on a variety of factors, but the main one is the risk of default. If a borrower is considered highly likely not to repay the full loan, the higher their interest rate would be.

How does inflation affect interest rates?

Inflation and interest rates usually have an inverse correlation. When interest rates are low, inflation rises – that is, the cost of goods and services increases. And when interest rates are high, it’s likely inflation will decline.  

However, it’s important to note that this relationship isn’t set in stone as during crises it is possible to see low interest rates and little inflation. This was the case amid the Covid-19 pandemic.

A key job of central banks is to keep inflation under control. They’ll have an inflation target that they’ll aim to stick to in order to stimulate growth without causing the cost of living to become too expensive. For the most part, this target is around 2-3% inflation per year.

Central banks will use the interest rate to manipulate inflation. By raising or lowering the cost of borrowing, they can influence the spending habits of businesses and consumers. Let’s look at each scenario.

Rising interest rates impact on inflation

When central banks increase the base rate, it raises the cost of borrowing which encourages banks to charge businesses and consumers more to borrow money. But it also increases the amount of interest paid on savings accounts, which encourages consumers to keep their capital in the bank. 

This lowers the levels of spending in the economy, causing a slowdown in economic growth. Money supply will tighten and the demand for consumer goods drops – having a knock-on effect on the bottom line of businesses.

The fall in demand, without a fall in supply, should make goods cheaper and lower inflation.

Lowering interest rates impact on inflation

When central banks lower the base rate, the rates passed onto consumers and businesses are also reduced. This makes it less cost-efficient to hold savings in bank accounts and more worthwhile to spend money and take out loans.

This causes the economy to grow as more money enters circulation, increasing demand for goods and services, and boosting income for businesses.

The higher the demand for goods, without a rise in supply, the more companies can charge for them. This is inflation. Some inflation is a good thing, but too much can harm the economy.

How do interest rates affect financial markets?

Interest rates impact the economy, businesses and consumers so the effects are felt in financial markets.

To better understand the impact of interest rates, we’ll divide financial markets into risk-off and risk-on assets. All financial assets involve a level of risk, so we’ll steer clear of the term ‘risk-free asset’ but some come with more danger than others when it comes to inflation and interest rates.

  • Risk-off assets are those that are reasonably certain to continue creating returns regardless of economic circumstances. Examples include bonds, notes and treasury bills (t-bills)
  • Risk-on assets are those that have significant price volatility depending on economic cycles. Examples include shares, commodities, and currencies

Interest rates and debt obligations (bonds, notes and t-bills)

Bonds and other debt obligations typically have an inverse relationship with interest rates. The longer the duration of the bond, the more sensitive it is to changes in interest rates as it takes longer for the decisions to be felt.

Bonds pay a fixed interest rate to investors. If interest rates fall, then this fixed rate becomes far more attractive for investors. But the easier it is to borrow money, the fewer companies and governments have to rely on bond markets, and so they can offer lower-yielding debt issues. So, even though demand for debt instruments rises – increasing the price of bonds – yields are likely to fall.

Conversely, when interest rates rise, a bond might not be as attractive as leaving cash in a saving account. The decline in demand means that bond prices usually fall. Bond investors might now expect a higher return in exchange for taking on increased risk.

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Interest rates and shares

Any changes to interest rates are usually felt pretty quickly by investors, especially with the rise of speculators who are specifically waiting for the news to come in.

When interest rates rise, stock prices tend to fall due to the negative impact on businesses. Consumers putting their money into savings accounts, rather than goods and services, reduces profit growth. Companies will then have less to distribute to investors, and speculators might take a more negative outlook on the stock in the short term.

On the flip side, lower interest rates can be positive for stocks due to the increased spending in the economy. Company profits will grow, increasing the likelihood of dividends and a bullish attitude from both investors and speculators.

The impact of interest rates on the stock market is also very subject to the current economic conditions – so context is crucial. When there’s fear of an economic downturn, low-interest rates can be just as negative for stocks.

For example, the Dow Jones index dropped significantly in March 2020 when the Federal Reserve cut interest rates to near zero amid the onset of the Covid-19 pandemic. Although low-interest rates are typically stimulating for the economy, the lockdown measures meant share prices tumbled.

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Interest rates and commodities

Historically, interest rates and commodities also have an inverse relationship.

One of the main reasons behind this is ‘the cost of carry’, which is the term used to describe the additional fees associated with holding an asset.

Research by Harvard University found that when interest rates are high, the cost of storing commodities also goes up. This makes businesses less willing to hold assets long-term, which can reduce the demand for commodities.

Couple this with the tendency for investors to look for better returns in savings accounts, rather than holding gold or silver, commodity prices tend to fall.

As interest rates fall, however, the cost of holding commodities also declines. Businesses become more willing to store raw materials again, and investors are switching back to more risk-on asset classes.

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Interest rates and forex

Interest rates are a key driver of the forex market. The interest set by a country’s central bank is one of the biggest determining factors in the value of a national currency. They affect how FX traders feel about one country’s currency in relation to another.

When deciding which savings account to use, you’d be more likely to choose one that was offering you a 2% interest rate, rather than just 1%. And the principle is the same for currencies.

The higher a country’s interest rate, the more likely its currency will strengthen. This is because more international parties are encouraged to deposit their money in the country's banks since they offer a greater reward. The 'hot money' increases demand for the country's currency, which pushes up the value of the currency. This makes imports cheaper in the domestic currency and more expensive in international currencies.

Discover what the strongest currency is.

Conversely, a country with a lower interest rate is seen as more likely to have a weaker currency. As less foreign capital flows into the country, it weakens the purchasing power of the domestic currency making imports more expensive and imports cheaper.

Typically, FX traders will buy a currency with a higher interest rate and sell a currency with a lower interest rate. This is known as a carry trade. The high interest accrued on the currency they’ve bought is added to any profits.

Learn more about forex interest rate strategies.

But while economic growth can take years to change, market sentiment can take mere seconds. That’s why releases of macroeconomic reports – like the Consumer Price Index – and central bank announcements are some of the most important events to watch for FX traders.

Discover how CPI impacts forex.

If there’s a rate hike, the domestic currency will appreciate. And if there’s a cut, it will fall. But sometimes markets are surprised, and all bets are off.

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