Interest rate effect

How interest rates affect: Individuals, Businesses & the Stock Market?

Interest Rate Effect

Once Janet Yellen ended the QE program of the US dollar, Interest rate hike as a topic started to be the most popular topic on the investors tables. Interest rate effect is a dilemma for everyone because it affects every single part in the economy directly so, reactions are interchangeable, mixed and must be well-understood to know where is every local currency is moving. Basically, Interest rate is the cost someone pays for the use of someone else’s money

Away from complicated details, I will simplify the effect of this important term through the following explanation

Inflation Definition and Impact

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money.

Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

Interest rate adjustment is one of the powerful tools which is used to control the inflation/deflation by the central banks

Interest Rate Effect on Individuals

Individuals are divided into two major types:

  • – Money Owner (individual who has extra money amount to invest or to save)
    • Increase in interest rate for this type of individuals mean the followings:
      • – Saving money (especially in banks) becomes much favorable for the majority of investors. Banks saving accounts, treasury bills and bonds offer competitive returns with lower risk if compared to stock market returns. Everyone knows that stock market is a high risk market.
      • – Lower spending desire because, money-saving is much tempting
  • – Money Needy (individual who has no/low money fund to get his/her needs and demands)
    • Increase in interest rate for this type of individuals mean the followings:
      • – Banks loans, credit cards, credit allowances and mortgage are much expensive
      • – Lower spending desire because, cost of borrowing is higher and less income available

Interest Rate Effect on Businesses

Businesses have different types too however, the effect of interest rate can be explained as follows:

  • – Businesses have 3 majors areas that are directly affected with interest rate increment
    • – Lower demand on their services and products driven by lower spending behavior from individuals
    • – Lower demand on the business services and products means lower profits for the business and lower returns on their stocks too. Then, stock price falls affected by the lower returns.
    • – Higher interest rate means higher borrowing costs for the businesses. Usually businesses borrow to expand and develop their sizes and operations. Higher interest rate will eliminate the business from expansion and growth.

Interest Rate Effect on the Stock Market

Stock market is directly affected with interest rate as follows:

  • – Stock market is the interaction area between the investors and the businesses. Higher interest rate will affect the businesses as I’ve mentioned above and this will push the stock prices lower. When stock prices are lower, this means that the whole market declines and its index(es) fall. Investors want appreciation for their equities overtime and falling stock prices and indexes will threaten their equities appreciation and lower their desires to invest in the stock market.

Question: Higher interest rate is a stock market killer?

The answer is: BIG FAT NO!

However, Interest rate is a correction flag for any stock market and it clearly means that a major correction might be coming in the near future, keep your eyes opened!.

What is important to know is that: Quantitative easing and low interest rate encourage investing in stock market and usually, the stock market indexes make new highs during the low interest rate periods and QE programs implemented by the governments. But, This does not mean that with a higher interest rate, you must sell your stocks.

There are other important factors affect the stock market so, do not panic. Corrections and consolidations usually happen every year.

What’s important is to watch the economic data releases to see how the economy of a specific country performs and based on this, you can sell and buy stocks.

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US early rate hike is good

isn’t April’s Fool: Early rate hike is good for the US economy!

Why does the Fed want to raise interest rate quickly?

Well, to understand this we have to zoom-out of the details of each economy for a while to see how world countries manage their local economies?

If we take 3 samples from the world economy and let’s pick: Japan, Eurozone and United states

In Japan, Bank of Japan offers (0.10%) interest rate and it maintained a plan to expand the monetary base at an annual pace of 80 trillion yen ($666 billion) from April, 2013

While in Euro Zone, European Central Bank offers (0.05%) interest rate and it announced an expanded stimulus program amounting to €60 billion ($69 billion) a month in asset purchases in an effort to revive the eurozone’s struggling economy till September, 2016

On the other hand, in United states. The Fed. tapered its (QE) stimulus program on October, 2014 and started to prepare the market for first-rate hike after keeping interest rate closer to 0% for years.

Let’s mix all the elements together and keep it very simple ..

Let’s say that these local economies are intersecting in international trade zone. Every economy is boosted by offering new money, low-interest rate and doing its best to keep inflation up to its targets.

In Japan, the inflation started to pick up however, it is not that strong to meet BOJ target till now. The reason behind this is low oil prices which might push BOJ to lower its inflation forecasts or give extra time for its inflation target to be achieved.

While in Europe, ECB just launched its QE program to encourage Eurozone members to revive their economies and between the lines to help Greece to get out its debts without suffering for long time (Read Quote#1). Eurozone still have at least 1 year till we can talk about inflation risk or even discuss whether economy started to pick up or not.

Quote#1: Weakened Euro

Weakened Euro is good for Greece because it implicitly means that Greece’s products and services are much cheaper for the foreigners and for the world. This help Greece to get out its financial problems by boosting up its economic activities. In addition, Liquidation for any foreign assets owned by Greece will get more Euros to Greece (~for example: US dollar saving account, foreign properties and foreign financial instruments owned by Greece worth more Euros than 6 months ago, from EUR/USD: 1.398 to EUR/USD: 1.0480 so, if you’ve 100$ in your pocket, they worth 71.5€ in the past and now they worth 95€)

On the other hand, the US economy is performing better as viewed by the Fed, Employment and home sales are moving forward and thats why they tapered the quantitative easing program. If we look to the US through non-risk taker(s) eyes, they would love to move funds, investments and capital to united states. (Read Quote#2)

Quote#2: Why does Investment move?

Funds, capitals and investments always search for better returns so, the money flows love to go to the higher return zone. In our article, US economy will be attractive economy for the capitals and investments. You’ve higher return on your capital, fund and investments. If you are not a risk taker, your returns in the US might be much higher than any other country.

.. & Early rate hike is good for the US economy

In the american case, the need for a rate hike seems to be so clear in yellen’s words and even in the fed minutes. However, the fed is still not-so-sure about how strong is the US economy and will it survive in a world of slow growth?

Based on the previously mentioned points, we are able to say that early rate hike is really good for the american economy and for the global economy too.

The only concern that we must concentrate on is how good the US economy performance is?

Solid employment, stable home sales and consumer spending backed with reliable data from industrial activities should be enough for the fed to press the hike button. This does not mean that US economy is moving backward. On contrary, Stronger dollar is rational power for the american economy and it opens the gate for cheaper imports and gives american investors better chances in foreign investments.

In addition, US market is not that weak and recent economic data showed that it is performing on a solid base to maintain economic growth for local industries and businesses.

Last thing, Experts are expecting that once US hits its inflation target, this will gradually export inflation to the other countries and thus, help the world to get out its deflationary period

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What is Inflation?

Videos: Get to know Inflation

Inflation is one of the most important and critical economics terms that everyone must watch closely, its importance comes from its effect on the international economy and how central banks highlight and consider it in all its monetary actions. We are here to help you with these easy videos posted by Bank of England (UK) – YouTube Channel (Full credits reserved to BOE with thanks for sharing such useful videos)

Inflation Definition

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money.

Let’s go through the following videos to know more about inflation ..

Video #1: What is Inflation?

Video #2: Why does inflation matter?

Video #3: How does the Bank manage inflation?

Video #4: History of inflation

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