What Do Lower Interest Rates Mean for Retail Investors?
After two years of interest rate hikes worldwide, we are on the cusp of a rate-reduction cycle. At the time of writing, the European Central Bank, the Bank of England, and the US Federal Reserve had all indicated that interest rates would soon be cut.
To the retail investor, this news will likely affect your portfolio in many ways. This is because when a central bank reduces its main interest rate, this monetary policy move has diverse impacts on various financial assets, including stocks, bonds, FOREX, commodities, and cryptocurrencies. To prepare you for what’s coming over the next few months, our experts at Arincen have put together this article to educate you on how each asset class might be affected.
What is inflation?
Maybe you’re a new investor. You’ll have heard about the term “inflation.” What is it, and how does it affect your investments? Well, the economic definition is that inflation refers to a continuous rise in the general price level, usually measured by the consumer price index (CPI) or other broad price indices.
It represents a decrease in a currency's purchasing power, as each unit of currency buys fewer goods and services over time. Consumers around the world will have witnessed how such everyday necessities as gas, food, and heating have become increasingly expensive.
Inflation is typically expressed as an annual percentage rate of change in the price level and refers to the sustained increase in the overall price level in an economy over time, reducing the purchasing power of money.
Why did interest rates go up in the first place?
Before going forward, let’s talk about what’s happened in the last two years. The world's major central banks hiked interest rates aggressively over that period to combat high inflation. Here are the key reasons behind the widespread interest rate increases:
High inflation after the COVID-19 pandemic disrupted supply chains and increased consumer demand. Central banks tried to cool overheated economies and bring inflation back down to their 2% targets by raising rates, making borrowing more expensive.
The early view that high inflation would be a passing phase proved incorrect. As inflation remained stubbornly high, central banks were forced to go to a more aggressive monetary policy tightening stance.
Strong labor markets and resilient economic growth, especially in the US, allowed central banks to lift rates rapidly without immediately causing recessions. The Fed led the world with 475 basis points of hikes.
Policymakers embraced the "higher for longer" necessity, agreeing that rates would stay elevated until inflation was controlled, even if it risked pushing economies into recession.
Lest we forget, there was also an undertone of central banks looking to re-establish their credibility in fighting inflation after being criticized for initially falling behind the curve.
So, the concerted global interest rate hike cycle over 2022-2023 was an aggressive attempt by central banks to regain control over soaring inflation by cooling demand and anchoring inflation expectations, despite the possibility of causing a recession.
Why would central banks need to reduce interest rates?
Over time, central banks achieved their aim, with inflation levels in many countries stabilizing, and then coming down. Now what? Well, central banks would need to reduce interest rates for a few key reasons:
To stimulate economic growth. Higher interest rates are intended to cool overheated economies and bring down inflation, but they also slow economic activity. Once inflation comes down to the central bank's target level, lowering rates helps encourage borrowing, investment, and consumer spending to support continued growth.
To prevent a recession, if high interest rates succeed in sharply reducing demand and inflation but also cause a severe recession with rising unemployment, central banks need to cut rates to provide economic stimulus.
It's important to deal with long-term high interest rates to help reduce long-term debts. These high rates make it more expensive for households, businesses, and governments to pay off debts, raising the risk of not being able to pay and making the financial system unstable. Lowering the rates helps to make these challenges easier to handle.
To maintain policy flexibility and conventional tools. Extremely high interest rates limit a central bank's ability to use rate hikes as a policy tool in the future if needed to counter inflationary pressures.
So, in essence, after using high interest rates as a blunt tool to bring inflation under control, central banks need to gradually reduce rates to their target level to support economic recovery without letting inflation re-emerge as a risk.
How lower interest rates affect financial assets
In the next section, we will talk about what to expect with regard to some of the more common financial assets:
Stocks
Lower interest rates can have a positive impact on stock markets in several ways. For companies, reduced borrowing costs make it cheaper to fund expansion, invest in new projects, or refinance existing debt, possibly leading to higher earnings and improved profitability.
This increased investment can drive economic growth, which is good news for various sectors. On the consumer side, lower interest rates lead to cheaper loans and mortgages, which in turn increase disposable income and encourage higher spending.
This boost in consumer spending can lead to higher revenues for businesses, further supporting stock prices. For example, after the Federal Reserve aggressively cut interest rates in response to the 2008 financial crisis, the S&P 500 experienced a substantial recovery, initiating a prolonged bull market. The lower rates helped restore investor confidence, stimulated economic activity, and contributed to a significant rebound in stock prices across multiple sectors, showing the positive impact of monetary easing on the equity markets.
As you can imagine, if consumer-driven sectors start to see more sales, they report higher profits, and this is reflected in their stock price. For the retail investor, now would be a good time to assess your portfolio and study your exposure to consumer stocks.
corporate Borrowing
This is linked to stock trading, but we’ve put it in its own section so you can understand the dynamics at play. Corporate borrowing becomes a good idea for firms when interest rates are low, as companies can access cheaper capital.
Reduced borrowing costs allowa firms to finance expansions, invest in new projects, and refinance existing debt at more favorable rates, which can significantly enhance their profitability. For example, a company might use lower interest rates to invest in research and development, upgrade infrastructure, or expand into new markets, leading to future revenue growth.
Additionally, refinancing existing high-interest debt with lower-rate loans can reduce interest expenses, directly improving net income. This increased financial flexibility often results in higher stock prices as investors anticipate improved earnings and growth prospects. Of course, you won’t be privy to companies taking out cheaper loans, but companies often announce major capital expansion projects, which are normally funded by loans rather than free cash.
This happened in the aftermath of the 2008 financial crisis. Central banks, including the Federal Reserve, slashed interest rates to near-zero levels to stimulate economic recovery. This low-interest environment allowed many corporations, like Apple and Microsoft, to raise substantial amounts of capital through bond issuances, which they then used for various strategic initiatives, including share buybacks, acquisitions, and technology investments.
In a case like this, these actions would not only support their balance sheets, but also fuel investor confidence, contributing to a robust recovery in stock prices and market valuations. The ability to borrow cheaply in such environments underscores a link among central bank policies, corporate financing strategies, and overall market performance.
Bonds
Interest rate cuts generally increase bond prices. When a central bank reduces interest rates, newly issued bonds frequently offer lower yields. Because of this, existing bonds with higher interest rates become more valuable because they provide better returns than the new issues.
This inverse relationship between bond prices and yields is a fundamental part of bond investing. However, while bond prices rise, the yields on newly issued bonds decrease, making them less attractive to income-focused investors. For example, during the early 2010s, the European Central Bank cut interest rates to stimulate the economy. As a result, the prices of German Bunds, which are government bonds, skyrocketed. Investors flocked to these existing bonds for their higher yields compared to new issues.
Additionally, lower interest rates often spur demand for bonds as investors seek relatively safer investments in an environment of reduced returns on cash and savings accounts. This heightened demand can further drive up bond prices.
However, there’s a flip side. As yields fall, the income generated from bonds decreases, pushing some investors to seek investments with higher potential returns, like stocks or high-yield corporate bonds. So, while interest-rate cuts generally benefit bondholders in terms of price appreciation, they also present challenges in finding attractive yield opportunities.
FOREX
Interest rate cuts can significantly impact the FOREX market by leading to the depreciation of a country’s currency. When a central bank lowers interest rates, the returns on investments denominated in that currency decrease, making them less attractive to international investors. As a result, investors often move their capital to countries offering higher returns, causing the demand for the lower-yielding currency to drop and its value to fall.
It’s called capital flight, and it can weaken a currency, affecting international trade and investment flows. For instance, when the Bank of Japan implemented negative interest rates in 2016, the yen depreciated against the dollar. Investors went in search of better returns in other currencies with higher interest rates, slashing the yen’s value.
Additionally, a weaker currency can boost a country's exports by making its goods cheaper for foreign buyers, potentially stimulating economic growth. However, it can also increase the cost of imports, leading to higher inflation. That’s why the depreciation effect of interest rate cuts should be of interest to traders, multinational companies, and investors holding foreign assets. This is because exchange rate fluctuations can significantly impact their returns and operational costs.
What does this mean for me as a retail FOREX trader? Well, understanding the relationship between interest rates and currency values is crucial to effectively navigate the FOREX market. You could follow the announcement of rate reductions by central banks and monitor the expected weakening of their currencies. When this happens, you could make trades against other, still-strong currencies. If you know how to work the markets, then volatility can be your friend!
Commodities
Commodities often benefit from lower interest rates in several interconnected ways, primarily driven by currency depreciation and more robust economic activity. As we have mentioned, when central banks lower interest rates, a weaker currency makes commodities priced in that currency cheaper for foreign buyers, thereby boosting demand on the global market. This increased demand can drive up the prices of various commodities, from agricultural products to industrial metals.
As we’ve also said, lower interest rates stimulate economic growth by reducing borrowing costs for businesses. This economic stimulus can lead to higher demand for raw materials and energy. For example, as construction and manufacturing activities increase, the demand for such commodities as steel, copper, and oil, increases. These sectors are directly tied to economic cycles, and their performance is closely linked to interest rate policies.
In the near-zero interest rate environment after the 2008 financial crisis, the value of the U.S. dollar dropped, which made commodities like gold more appealing to investors as a way to protect against currency devaluation and economic instability. As a result, the price of gold increased, confirming its role as a safe-haven asset during periods of monetary easing and financial uncertainty. Gold prices rose from about $800 per ounce in 2008 to over $1,900 per ounce by 2011.
Similarly, other commodities such as oil and agricultural products experienced price increases due to the combined effects of a weaker dollar and recovering economic activity. For example, oil prices rebounded sharply from their lows during the crisis as global demand picked up in response to the economic stimulus provided by low interest rates.
Remember, lower interest rates reduce the carrying costs of holding commodities. Investors and companies that store commodities benefit from reduced financing costs, making it more economical to hold larger inventories. This can also support higher commodity prices as it encourages stockpiling and speculative investments in anticipation of future price gains.
As a retail investor, you should be on the lookout for a more favorable environment for commodity prices, as they can be a highly attractive investment during periods of monetary easing.
Cryptocurrencies
Cryptocurrencies can experience a range of effects from interest rate cuts, influenced by increased liquidity and investor behavior. When central banks lower interest rates, increased liquidity within the financial system often follows. More money means more investors trying out riskier assets, including cryptocurrencies, as they look for higher returns than traditional savings accounts and bonds. As we’ve said, lower interest rates can also result in a weaker national currency, pushing investors to seek other stores of value like Bitcoin and other cryptocurrencies.
A word of caution: the impact of interest rate cuts on cryptocurrencies is not uniform and can vary widely based on market sentiment, regulatory developments, and technological advancements within the crypto space. Additionally, the speculative nature of cryptocurrencies means they can be highly volatile, responding rapidly to both positive and negative news.
Further, the broader acceptance of cryptocurrencies as legit financial instruments continues to evolve, with increasing institutional interest and integration into mainstream financial services. For example, the rise of Bitcoin exchange-traded funds has given consumers more security in trying services that operate outside traditional banking systems.
While lower interest rates can boost investment in cryptocurrencies by increasing liquidity and driving demand for alternative assets, the true impact is shaped by a complex interplay of market dynamics. You should remain aware of these factors when considering cryptos in your portfolios, as their performance can be highly unpredictable.
Let’s Recap
Change is coming! Lower interest rates are a natural follow-on from a high-interest-rate period. As you navigate the investment landscape of lower interest rates, you should pay attention to their multifaceted impacts on various asset classes.
Lower rates can enhance your portfolio's performance by boosting stocks and bonds, while making commodities and FOREX trading more attractive. However, these benefits come with a caveat. The interplay of market dynamics, economic conditions, and regulatory changes can introduce volatility, particularly in more speculative investments like cryptocurrencies. By staying informed and adaptable, you can capitalize on the opportunities presented by a lower interest rate environment while mitigating risks. Remember, a well-diversified portfolio and close monitoring of market trends are key to achieving long-term financial success.
FAQ
How do lower interest rates impact stock markets?
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What is the relationship between lower interest rates and cryptocurrencies?
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