What do higher interest rates mean for investors?
One of the largest shifts in the financial world over the last couple of years has been the return of inflation and with it, higher interest rates.
Inflation had been steadily falling since the early 1990s. For most investors under the age of 50, that has been their entire adult life. The reality has been low inflation, and banks offering low, or no, interest rates. This has been good if you are a borrower, securing a mortgage to buy a house at a low interest rate, for example (albeit at an increasing price). It has not been so good for savers though, as most banks offered next to no return on your cash. In recent years, many banks in Europe were even offering negative interest on your money.
What has changed in the last year is that inflation has risen, and in response, the central banks have increased the official interest rates. In the EU, the official cash rate has gone from being negative, at -0.75% pa to 3.75% in less than a year.
This creates a markedly different financial environment. The reason central banks have done this is to reduce inflation, but the by-product is changes to the investment market.
The graph below shows the official cash rate set by the European Central Bank since 2014, noting the increases in the last year.
We stated that central banks increased interest rates to control inflation. This is apparent if you look at a graph of inflation over the last 20 years. The graph below illustrates the impact of inflation over the last year. Its causes were from a few years prior, and it is coming down from its 2022 highs, however, is still notably above long term trends at current levels.
There are two issues here. One is that higher interest rates mean it might be possible to get a better return on your cash, and two, with inflation higher, you need to get a higher return on your cash.
Along with increases in the official cash rates, the potential returns on your cash in the bank have actually gone up.
What has not changed though, is that most bank solutions are still offering less than inflation.
We always advocate that it is important to maintain an amount in cash when it comes to financial management. You should generally have sufficient liquid funds to cover for unexpected expenses and emergencies. Beyond that, though, too much cash in a bank, that is earning less than inflation, means you are eroding your wealth over time. The rate at which you are going backwards is the difference between the interest rate you are receiving, and the inflation rate. We would normally exclude your emergency reserves from this analysis. A note: it is important to remember that that everyone’s situation is different, and you should not make big decisions without advice that is specific to you.
As most banks are now offering better returns on cash, it is important to look at the details. Here are some important questions to ask.
as we mentioned above, most banks are still offering interest rates a long way below the official cash rates. Find out the interest rate they are offering.
Find out the minimum amount required for a given interest rate.
Many of the offers come with terms and conditions, so read the fine print. For example, we saw a bank advertising 3.5% per annum on cash. This looks good! To achieve this rate though, you have to lock your money into a fixed term deposit for 5 years, with the interest only added at the end of the term. That means if you need to access the funds in the meantime and need to break the deposit, you might not receive the expected return.
Don’t ignore the fees. A bank account offering 1% per annum on a €10,000 cash account, that also charges €8.50 pe month to maintain the account, leaves you just about breaking even.
Finally, and most importantly, understand what you are trying to accomplish, what your needs are for this amount of money and ensure that what is being offered matches what you need, including allowing for the contingency of emergencies. Make decision based on your needs and objectives.
If you would like more information, or would like advice on how to manage your cash and other assets, feel free to contact us by email at info@extinvestments.com or visit our website, www.blackswancapital.eu.
