3 November saw the Bank of England (BoE) raise interest rates by 0.75% to 3%, a decision which made headlines across the country as the biggest increase in more than three decades.
Whilst this is certainly headline grabbing news, what do interest rate movements mean to investors? Why are they important and, most importantly, why would the BoE make interest rates higher during a cost-of-living crisis? This blog dives deeper into the topic of rising interest rates and explores what this means to investors in the current climate.
What is the base rate?
The base rate is the interest rate the central bank, or the BoE, sets which determines the interest rate paid to commercial banks holding money with the BoE or the interest charged to the commercial banks for borrowing from the central bank. This then influences how much the commercial banks charge people to borrow, or the interest paid on their savings.
The rate charged to individuals and businesses significantly impacts the amount of money left available for other areas of spending. For example, a £150,000 repayment mortgage at 3% over a 25-year term would cost £711.32 per month. If we increase the rate by 3% to 6%, this will cost £966.45, a noticeable difference. The increased challenge of servicing debt applies the same to businesses, impacting the profitability of companies servicing the debt.
How does it affect investors?
Most investors, particularly those invested in a diverse portfolio, will be invested in equities and bonds. The equity content of a portfolio comprises of businesses who will have some form of debt being serviced. If the cost of servicing this debt goes up, this means their profit goes down, typically resulting in a drop in the share price. It is the growth focused, tech orientated companies whose values soared the fastest over the past decade which have been impacted most by recent hikes in interest rates, typically due to their highly leveraged and forward-looking nature. We have seen a significant sell off in equities recently, rising interest rates certainly having an impact on these downward movements.
Bonds are vehicles to invest in debt, often used as a diversifier against equity. Bonds have an inverse relationship with interest rates, meaning when interest rates go up, the price of bonds go down which is what we have seen a lot of this year. Bond yields, which pay out to the investor, go up in line with interest rates meaning those looking to invest can buy bonds at similar risk levels, but with a higher yield payment.
Rapidly rising interest rates bring a heightened level of volatility in most areas of the global investment market. The recent rises in interest rates certainly played a major role in the increased levels of market volatility we have been experiencing since the beginning of the year.
Why are central banks raising rates during a cost-of-living crisis?
At first glance, a central bank decision to hike interest rates during a cost-of-living crisis and headline inflation figures seems particularly counterintuitive. Why would the central bank raise rates, effectively shrinking the economy at a time where the cost of living is increasing? The simple answer is inflation.
Inflation remains at the forefront of all policymakers’ minds. The threat of a continuing surge in inflation could result in a far deeper economic crisis than we can plan for. Getting inflation under control is vital for the long-term wellbeing of the economy and whilst it may initially seem counterintuitive to raise interest rates in tough economic conditions, the Monetary Policy Committee at the BoE, which sets interest rates, must use rate increases as their primary tool to combat inflation. The purpose of raising interest rates is to cool the economy down. Heightened economic activity fuelled by pent up demand and logistical backlogs has resulted in the inflation figures we see today. Without cooling the economy somehow, inflation would continue to surge. Higher interest rates mean consumers receive a higher rate of return for leaving their money in the bank, as well as reducing disposable income levels due to higher loan repayment figures. This combination of reduced disposable income and a greater incentive to save should cool demand in the economy which in turn should see reduced inflation figures over time.
What does this mean for my portfolio?
2022 has been a challenging year for most investors, particularly those in medium and lower risk style investments who have gone through a more volatile journey than usual. The macroeconomic environment has changed, and we no longer find ourselves in a low interest rate economy. However, despite this our message at Francis Clark Financial Planning remains very much the same – to keep the original goal in mind and take the long-term view; it is panicked knee jerk reactions which are most likely to lead to the worst ramifications to a long-term plan.
The value of your investment can fall as well as rise and is not guaranteed. Past performance is not a guide to future performance.