Interest Rates and Financial Markets

Put simply, interest rates are the benefit you receive for saving, and the cost you incur for borrowing. Usually set by national governments or central banks, interest rates have a huge impact on various parts of the economy, particularly the financial markets. This article will explore in detail the impact that interest rates have on Equity Capital Markets (ECM), Debt Capital Markets (DCM) and the Forex Markets (FX Markets), before concluding with an overview of the current global trends in interest rate policy.

The Equity Capital Markets (ECM)

Being a synonymous term for the stock markets, the equity markets (like most of the financial world) can be heavily impacted by changes in interest rates. This impact can occur for numerous reasons. Whilst evidence suggests that consumer and business responses to interest rates happen over the course of twelve months, the equity markets are a lot more reactionary.

In the event of an interest rate increase, it is generally expected for stock prices to fall. The fall in price results from two main factors: the cost of borrowing and the decrease in consumption. Increases in interest rates increase the cost of borrowing, making it more expensive for firms to finance future ventures which could negatively impact earnings. The equity market’s response therefore is for share prices to fall as investors sell their shares. Interest rate hikes also decrease consumption because saving is made more attractive. Consequently, with less consumers in the market, share prices fall due to the belief that a lack of consumption is going to decrease company earnings.

When there is a decrease in interest rates, effectively the opposite happens. Share prices rise because borrowing is cheaper and so firms can invest more. Meanwhile, as saving is made less rewarding, consumers look to spend their money in the economy. Increased investment and greater consumption both lead to growth in firms, which is why the reaction in the stock market is a positive one.

As seen in above in Figure 1, research by J.P. Morgan Asset Management suggests this generalisation to be valid. However, there are some anomalous sectors to interest rate changes. Most notably is the financial sector because whilst increases in interest rates may impact investment levels, banks are able to charge a higher rate for borrowing and so earnings could actually increase.  
In summary, when interest rates increase, generally expect a fall in the equity markets whilst when rates decrease, expect a rise in the equity markets.

The Debt Capital Markets (DCM)

The Debt Capital Markets are another segment of the financial world which is greatly impacted by interest rate alterations. Mainly constituting Corporate and Government Bonds, this market is extremely reactive to even the slightest change because most bonds pay at a fixed interest rate. This means that when interest rates change, a bond’s value can either go up or down.

Bonds have an inverse relationship with interest rates, meaning that when interest rates go up, bond values go down and vice versa. A rise in interest rates means newly issued bonds would have a higher yield than those currently on the market, leading to a fall in price of the older bonds (known as a discount). On the other hand, falling interest rates make older bonds more attractive and increase their value, which is known as a premium.

What influences the price of bonds is a hotly debated topic, however some believe the biggest risk to bond prices is interest rates and the associated interest rate risk. The theory hypothesises that the longer the time to maturity on a bond, the greater the interest rate risk because there is a greater chance that interest rates will fall below the yield of a given bond. Thus, the hypothesis is self-evident in emphasising the importance of interest rates in relation to the DCM. In the wake of the huge influx of debt issuance resulting from the COVID-19 pandemic, it will be interesting to see how future interest rates influence the value of this debt.

The Forex Market (FX Market)

The Forex Market is a decentralized market concerning the trade of currencies. Interest rates play a huge role in the FX market with slight adjustments making huge changes in the values of currencies. This impact ultimately comes down to what is known as ‘Hot Money Flows’. To explain this term, it is best to use an example. Let’s suppose that interest rates in the UK increase. This boosts the return on saving in a UK bank account. Consequently, people look to put their money in a UK bank account to accumulate more interest on their savings. This increases the demand for GBP and leads to an increase in the exchange rate. In this way, a rise in interest rates equates a lot of the time to a hike in the exchange rate. It also works the other way around, wherein a fall in interest rates can lead to individuals looking abroad to place their savings somewhere they can get a better return. This would result in a fall in demand for GBP and decease the exchange rate.

When looking at fluctuations in the Forex markets, it is important to consider the impact that a change in one currency can have on another. Many currencies are fixed and may be pegged to others. An example would be Saudi Arabian Riyal (SAR) which is pegged to the USD. Therefore, changes in the interest rate in the US, if they effect the exchange rate, would also influence the value of the SAR. It is in this way that the impact of interest rate changes can have a ripple effect throughout the global economy.

Current Trends in Interest Rates

The rates experienced today are at all-time lows. The Bank of England chose in March 2020 to cut the base interest rate to a historic 0.1%, emphasising the impact that the COVID-19 pandemic has had on investment and consumer confidence. [2] Across the Atlantic, the US Federal Reserve has chosen rates of 0%-0.25%. [3]There has also been speculation of negative interest rates though it is a hotly debated discussion. These significantly low rates look to gauge investment from companies to re-establish the health of the global economy. Resulting from this, if theory stands true, ECM and DCM should appreciate in the coming months whilst FX Markets may struggle. However, it is integral to bear in mind that foreign exchange rates are also affected by an array of factors such as politics and fiscal stimulus. Thus, the affect that these low interest rates have on the FX Markets may be limited.

Overall, it is clear to see the potential impact that interest rate changes can have on the financial markets. It will be interesting to monitor the performance of ECM, DCM and FX Markets in the coming months to see their response to any further changes in interest rate policy resulting from the COVID-19 pandemic. Will the markets bounce back to pre-COVID highs, or will the market uncertainty and volatility prevail?