In-depth Analysis

How to benefit from rate hikes as an investor?

For most of the developed world in 2022, the impact of global supply chain issues and CCovid-19-relatedshutdowns on manufacturing continues to linger as a major issue. With the help of massive government stimulus packages during the pandemic, demand has been well out of balance with supply, and lately, the cost of energy has also been on the rise. The result of these widespread challenges has caused some of the worst inflation figures for decades. To decrease rising prices, central banks decided to aggressively increase their interest rates, even if it means threatening global growth prospects. Nonetheless, rate hikes also offer great trading and investment opportunities for wise traders.

Understanding the importance of central banks in the fight against inflation

The creation and distribution of currency and credit within a country like the United Kingdom or the United States, or a regional bloc of countries like the Eurozone, are delegated to a single financial institution known as the central bank. In today’s economies, the central bank sets monetary policy to reach its goals, which usually are to provide price stability and full employment.

Once inflation starts to get out of control, and above the usual 2% mandate of central banks, policymakers will typically intervene to cool consumer demand by making it more expensive to borrow money (mortgages, personal loans, business loans, and credit cards for instance). They do this by putting up interest rates.

These rates we’re describing are actually those that banks use to lend money to each other, typically called “benchmark rates”, depending on the main interest rates of the central bank that supervise them. However, the increase is almost always passed on to the consumer too.

The difficulty being faced at the moment, in 2022, is the balance that most of the central banks are having to strike between maintaining price stability and sending their economies past the point of cooling into a full-blown recession or worse.

How does monetary policy impact major investment classes?

Central banks are one of the most influential actors on the financial markets, as they can add or remove money flows within their economies depending on their goals, which will impact the value of almost all financial assets.

Stocks

Depending on the type of stock, interest rates rising and falling can be very impactful.

Across the board, when monetary policy is tightened, many retail investors will sell their holdings based on the cooling of market sentiment. As the price of lending goes up, many traders, businesses, and companies will have to cut their spending. Conversely, when monetary policy is loosened by cutting interest rates, the mood in the market may be more optimistic, and retail investors may be more inclined to buy.

Growth stocks such as tech companies like Apple, Netflix, or Amazon, as well as firms in the luxury and industrial sectors, generally rely on borrowed capital for their business to expand . When interest rates are on the rise, they have to pay more for their financing, and their cash flow balances can start to look less favorable.

In addition, some of the products that are marketed by these types of companies are seen as less essential to the population in times when they may have less disposable income, and so their value can be further damaged.

Companies that are not reliant on cheap borrowing to continue operating successfully are in a good position to ride out interest rate rises. These might be retailers of essential consumer products, household items, or industrial goods, for example. These companies are often known as “value stocks”.

Also enjoying increased profit margins during rate hikes are companies in the financial sector, such as insurance companies, brokerage firms, and banks, among others, as they’re able to pass on a higher interest rate to the consumer for their loans and potentially increase their margin. However, higher interest rates might also mean a more gloomy economic outlook, which might weigh on their activity.

Bonds

Bonds and interest rates move in opposite directions and are therefore very sensitive to movements in monetary policy. As interest rates rise, the price of bonds goes down, and vice-versa.

To be competitive and attractive to investors, new bonds are generally issued with a yield or ‘coupon rate’ that matches or is in excess of the prevalent market interest rates.

Because the majority of bonds generally pay out a fixed coupon rate to the investor, a higher-yielding bond can become more attractive and in demand. On the flip side, when interest rates increase, the bonds that were issued with lower coupon rates become less desirable and this generally results in a sell-off for lower-yielding bonds.

Forex

One of the major factors that impact the Forex market is the interest rate differentials between countries, which depends on monetary policies.

If, for example, the US lifts rates to combat inflation, and their key interest rate is higher than other countries, like the UK and the Eurozone right now, investors will tend to move their focus to the US, where assets yield more from these increasing rates.

In order to transact in the US, investors must first sell their own local currencies and purchase USD. This lifts the demand for the USD and reduces supply, further strengthening the dollar and weakening other currencies.

This is proving true at the time of writing, where the pound and the euro, among others, are weakening significantly against the dollar and looking to settle below parity for a while.

Commodities

Commodities are affected by a number of factors, besides interest rates, that impact supply and demand.

As interest rates rise, they may make it more costly to store or hold inventories, which might mean that more supply is available to the market instead of being stored. This potentially waters down demand and prices may drop as a result.

When the United States increases its interest rates, the American Dollar strongly increases, just as we’ve seen in 2022. A stronger USD hurts commodities, as they are priced in USD. Therefore, the greenback and commodities usually have an inverse relationship, meaning that they move in opposite directions.

When interest rates are increased quickly, the risk of recession increases, which means that the demand for commodities such as oil, aluminum, or copper, might be lower, as economic activity is expected to slow down.
Other commodities, like precious metals such as Gold, might benefit from the uncertainty about global growth prospects when recession or stagflation risks arise.

Final word

Central bank monetary policy, whether in a tightening or loosening cycle, can be very significant to every asset class. It can, therefore, have a strong impact on your trades and portfolio holdings.

Therefore, it’s critically important to educate yourself about the mechanism and targets of these policies, so that you can see challenges arise before the majority of other traders do. It will also help you balance your portfolio in a more relevant way to take advantage of new business and economic cycles.

And remember – it’s essential to do your homework, stick to your established trading and risk management plan, and always use a reliable and regulated broker, like ActivTrades.

 

 

 

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