How interest rates impact your financial planning and your life
This time one year ago, the main topic of financial conversation was around inflation. We had seen a spike and the highest rise in inflation in 30 years, as a product of the extensive, and necessary, capital support to the economies by major central banks around the world during the Covid 19 crisis. When that much money is pumped into the market, as we said at the time, it had to be reflected somewhere, either in the form of higher taxes, or more likely, and as was the case, higher inflation.
Perhaps because inflation was accelerated by the shortage of supply of many goods, rather than the increase in demand, and because of proactive and aggressive actions of central banks in increasing interest rates, inflation has come back down to the level, where approaching mid-2024, we are in the broadly long-term average range.
As stated above, one of the ways the central banks tackled the high inflation was to increase interest rates. The question for this article is what these higher interest rates mean for you, your investments, and your financial plan.
The key area of focus has moved from inflation to interest rates.
In the 10 years following the global financial crisis of 2008 -09, up until the last 18 months or so, there was an investment reality many called ‘TINA’. The acronym TINA stands for ‘there is no alternative’. What it meant was that with interest rates very low and in Europe even negative, asset classes like fixed interest (government and corporate bonds), and cash were not viable investment options if your objective was a return that was higher than inflation. Accordingly, investments were directed to equities (shares) and property, because there was not alternative.
That situation has changed.
You can now receive a positive return on your cash from your bank. Depending on the institution it may be higher or lower than inflation, so remember if your objective is to maintain purchasing power, and your return is less than the rate of inflation, you are actually going backwards.
The other area that has changed is fixed interest, also called bonds. To read more about bonds, you can see the article we wrote about fixed interest here. as a very brief summary, a bond investment is where you lend money to a government (or a company) and they promise to pay you a return at a given interest rate for the term of the loan, and at the end you get your capital back. Before the recent interest rate increases, the major government bonds were offering less than 1%per annum, and some, like Germany were offering negative interest rates. Now, you can get a German government 10 year bond at 2.5% pa and a US 10 year government bond at 4.5%.
The impact on your financial plan and its application through the types of investments you hold is that TINA no longer applies. There are alternatives, and depending on your goals, your time frame, your risk profile, and other factors that apply to you specifically, you may have these incorporated into your plan.
The next point about interest rates, is that they tend to move in a cycle. When they are low, they rise, and after they have risen, they will fall again. Therefore, it is likely that the next direction of interest rates will be down. That may be this year, or next year but to be clear one cannot predict markets, we can though plan and have contingencies for changes. When interest rates do go down, the change in rates will have an impact on different investments and that impact may be in different ways.
If interest rates fall, the returns you can get at your bank will also fall. This is important to watch to measure that real rate of return you are receiving, relative to inflation.
If you are a lender though, borrowing money for a mortgage or other purpose, lower interest rates mean cheaper repayments if you are on a variable rate. If you have a fixed interest rate you are insulated from these changes.
Interestingly, falling interest rates can impact some share prices. If companies have maturing debts they need to reissue and interest rates are falling, it might mean their cost of borrowing drops, leading to higher profits and an increase in share price. It can go in the opposite direction if cost of borrowing increases.
Falling interest rates can also mean more favourable returns on the fixed interest component of your financial plan. There are several factors that can influence the actual price, but I will avoid going into too much boring detail. To keep it brief, as we mentioned above a government issues a bond at a prevailing interest rate, and recently those rates have increased. Bonds can also be traded on what is called a secondary market. As an example, if you have a US government 10 year bond issued at 4.25%, and interest rates drop so their next issue is at 3.75%, the one you are holding can be sold at a premium on the secondary market, increasing your return. This can increase volatility and sometimes it is better t just hold to maturity, but the summary point is that falling interest rates can be good for the fixed interest component of your portfolio.
A change in interest rates then, can have an impact on the way you manage your financial to achieve your financial goals and reinforce why it is important to review your financial plan regularly.
We recommend if you have a financial plan or strategy in place that you haven’t looked at for some time, to contact us. We can review this with you to ensure you are on track, aligned and up to date with what is going on in the world. Contact us at info@extinvestments.com and we will be happy to speak with you.
