The Impacts Of Interest Rate Shifts On Different Investments

A graph of the federal funds rate from 1954 to 2020.

Interest rates play a crucial role in determining the performance of investments. Central banks, including the Federal Reserve in the United States, when adjusting interest rates, determine how well everything performs, from stocks to bonds to real estate. Investors need to keep up with these changes because they determine how much money they gain or lose. In this article, we will explain how changes in interest rates impact different investments.

What Interest Rates Are and How They Change

Interest rates are the cost of borrowing money, and banks impose this rate when lending to individuals or firms, and a base rate set by central banks kind of creates an “industry standard” for the whole economy. The Federal Reserve, for example, sets the federal funds rate, which is the rate at which banks pay to borrow overnight from each other. If the economy is expanding too quickly, the Fed can raise rates to slow it down. When growth slows or recession comes, on the other hand, they lower rates to encourage borrowing and spending. These decisions affects investments as well, since they change how much money flows into different assets.

Everything starts with the goals of the central bank. They look at inflation, unemployment, and economic growth. When inflation gets too high, higher rates reduce it by making loans more expensive. If there is less borrowing, there is less spending, and prices stabilize. Lower rates, as somewhat mentioned before, make people borrow and spend more, which is good when there are few jobs or businesses are doing poorly.

How Interest Rates Influence Bonds

Bonds are sensitive to changes in interest rates. A bond allows a company or government to borrow money from an investor, which earns investors interest along the way. The value of a bond tends to move contrary to interest rates. When there is an increase in rates, new bonds with higher interest payouts are issued, and hence previously issued bonds at lower rates diminish in value. Investors sell those older bonds to buy the new ones, driving prices down. When interest rates fall, however, better-paying outstanding bonds are more attractive, and their prices rise.

All of this applies to anyone who owns bonds. If someone owns a 10-year bond with a 3% interest rate and new rates rise to 5%, that old bond won't sell unless its price drops low enough to match the new rate of return. The investor could also lose money if they sell prior to maturity. Bond funds, which have numerous bonds, also have their values decline when rates increase. Long-term bonds are hit the hardest because their prices move more with rate changes. Short-term bonds don't fluctuate as much because they mature sooner and are reinvested at new rates sooner.

Stocks and Interest Rate Movements

Stocks aren’t any different because they also react to interest rates, though less directly than bonds. When rates rise, companies must pay more to borrow money. Higher borrowing costs leads to lower profits, especially for companies using debt to grow. Due to lower profits, such stocks are sold by investors, driving down prices. In the meantime, higher rates make bonds and savings accounts comparatively more attractive than stocks. Thus, people shift money out of the stock market, putting further pressure on prices.

Not all stocks respond equally. Banking stocks do well when rates go up because they earn more on loans and pay only moderately on deposits. Technology companies, though, are typically harmed because they borrow heavily to fund growth, and higher rates raise their operation costs. When rates fall, the opposite happens. Borrowing is cheaper, income is higher, and equities are more appealing than low-yielding bonds or savings. Growth stocks, including technology stocks, usually rise more in this setup. The overall stock market reflects these trends, but specific businesses vary based on their financial situation and industries.

Real Estate and Interest Rates

Real estate, as you may have guessed, is also strongly connected with interest rates, as most people buy real estate with mortgages. When rates increase, it is more expensive to make mortgage payments. A 3% $300,000 loan is cheaper than the same loan at 5%. When prices are higher, fewer can afford homes and less demand exists. Home prices may level off or fall as a result, and real estate investors receive lower returns. Developers also have to pay more to finance projects, reducing the amount of new construction. Rental units also feel the impacts because landlords have to pass on borrowing expenses to tenants or put off buying new units.

Lower rates do the opposite. Mortgages are affordable, and more prospective buyers enter the market. Demand pushes housing prices up, to the benefit of property owners. Real estate investment trusts that own and trade in properties tend to see their stocks increase as well. Investors like real estate when rates are low because it provides steady income and appreciation. But the catch is, when rates are low for a long time, it can cause a housing bubble, and a sudden rate increase later can hurt greatly.

Savings Accounts and Cash Investments

Other cash options and savings accounts track interest rates directly. As rates increase, banks offer more on savings accounts and certificates of deposit. Someone with money in a high-yield savings account receives more in return without risk. This flow pulls money out of stocks or bonds for those looking for safety. Cash is more desirable when rates are high, especially for retirees or saving for short-term goals.

When interest rates drop, the environment changes. Savings accounts yield little, and keeping cash handy is not desirable. Inflation may outpace the very low interest rate earned, diminishing purchasing power in the long term. So, during times like these, savers are encouraged to invest in stocks, real estate, or bonds to beat inflation.