Interest rates: what they are and how they affect investors

Find out what interest rates are, how they work and how they affect your investments. 

On virtually the same day in April, two pieces of news had euro and dollar holders on edge. A presidente do Banco Central Europeu (BCE), Christine Lagarde, president of the European Central Bank (ECB), announced at a press conference that the battle against inflation had been won and that she was preparing to cut interest rates soon. At the same time, a US report showed the economy remained strong despite higher-than-expected inflation. In response to this, the US Federal Reserve announced that it had no plans to change the key interest rates in the world’s largest economy. 

This broke with the longstanding tradition of the two organisations of pursuing parallel monetary policies and it did not take long for this to be felt. By the end of the same week, the euro was on course for its biggest fall in 19 months. Typically, higher interest rates encourage investors to hold on to their currency, which in turn tends to appreciate against other lower-yielding currencies. 

Times like this highlight the importance of monitoring changes in interest rate. Understanding this variable and factoring it into your investments is fundamental to managing risk and taking advantage of opportunities. Here’s how to do it 

What are interest rates?

Interest rates are the price paid for borrowing. In other words, it is the amount you pay when you use someone else’s money for a certain period of time and then return the principal plus an income (interest). This is the opportunity cost of foregoing the use of one’s own money while someone else, who has no capital of their own, borrows that money to carry out their consumption or investment projects, paying interest at the end of the contract (this is the cost of the loan or borrowing). Interest rates reflect the time preferences of those who postpone consuming or investing (by lending their money) and those who anticipate consuming or investing (by borrowing).

Risk, time, scarcity, inflation, economic trends and central banks all affect interest rates. The riskier the loan, the higher the interest rate, and the longer the loan, the riskier it is, so the interest rate tends to be higher. Strong economic activity can lead central banks to raise interest rates to curb potential inflationary surges.

With more activity comes more money, more liquidity and more money to lend, so the price of money tends to fall.  No wonder that managing this "price” is one of the most powerful tools available to central banks.

INTEREST RATE ON NEW LOANS GRANTED BY BANKS TO COMPANIES – ECB 

Source: Banco de Portugal

During periods of strong economic growth, demand for goods and services increases, which can lead to higher prices, in other words inflation. To prevent inflation from getting out of hand, central banks can raise interest rates, making credit more expensive and slowing down the economy. On the other hand, in times of recession, central banks can lower interest rates to stimulate consumption and investment. Lower interest rates make borrowing cheaper, which can help stimulate the economy.

These decisions will, of course, affect conditions throughout the financial market, including interest rates for individuals and businesses applying for financing. Typically, when a central bank raises its policy rate (the interest rate charged between banks), it effectively makes the cost of money more expensive for everyone, from banks to companies and individuals. A fall in the policy rate has the opposite effect.

Types of interest rates

Interest rates can have an impact on investment strategies, so it is important to understand what they are and how they can affect you. 

Nominal vs. real interest rates

The nominal interest rate is the interest rate that has not been adjusted for inflation. For example, if you have an investment that pays 5% a year, this is the nominal interest rate. The real interest rate, on the other hand, is the inflation-adjusted rate, which reflects the real purchasing power of your investment income. To calculate the real interest rate, you need to subtract the inflation rate from the nominal interest rate. For example, if the nominal interest rate is 5% and inflation is 2%, the real interest rate would be 3%.

In a high inflation environment, the real interest rate can be significantly lower than the nominal interest rate, which affects the real return on investments. It is therefore important to take this into account when assessing the real return on your portfolios.

Fixed vs. variable interest rates

As the name suggests, fixed interest rates remain constant over the life of the investment, providing a degree of predictability. Investors have a greater degree of certainty as to how much they will pay or receive in interest payments. Variable interest rates, on the other hand, fluctuate in line with changes in market rates, often linked to a reference rate such as the 3, 6 or 12 month Euribor.

What does this mean for borrowers? In a rising interest rate scenario, a fixed rate may be advantageous as it can protect borrowers from cost increases. On the other hand, in a falling interest rate environment, a variable rate may offer some savings. Investors should assess their risk tolerance and market outlook when choosing between fixed and variable rates.

Conversely, in a rising rate scenario, savers should look for a variable rate as they can benefit from rising rates. On the other hand, in a falling interest rate environment, a fixed rate may provide some additional income from a higher interest rate setting. Savers should also consider their risk tolerance and market outlook when choosing between fixed and variable rates.Benchmark or policy rateThe benchmark (or policy) rates are the interest rates that the ECB charges banks for loans. These rates affect the interest rates charged by European banks on loans and deposits. In turn, this rate is reflected in the cost of funding for economic agents with their banks.

Decisions on policy rates have a direct impact on investment returns. They can even trigger large-scale adjustments in financial markets, affecting everything from mortgages to corporate bonds. That’s why investors should monitor central bank policy to anticipate interest rate movements and adjust their investment strategies.

Short- and long-term interest rates

Short-term interest rates are money market rates, such as the Euribor in the euro area, with a maturity of up to one year and are directly influenced by the central bank. Long-term interest rates, on the other hand, have a maturity of more than one year and correspond to capital market rates, such as government bond yields.

What to consider before investing

When it comes to interest rates, here is what you should consider before investing.

1. Assess the economic context

Before investing, you should understand the economic context of the target market, including interest rate trends, inflation and economic growth. Understanding this helps you make informed decisions about when and how to invest. It is important to keep abreast of market and macroeconomic events. Information such as Banco Carregosa’s Quarterly Outlook can help you make more informed decisions.

2. Calculate the real rate of return

Take into account not only the nominal interest rate offered by the investment, but also expected inflation. Calculate the real return by subtracting inflation from the nominal interest rate to understand the real return.

3. Analyse interest rate forecasts

Study the central bank interest rate forecasts for the markets in which you intend to invest. Track central bank statistics, publications and meeting calendars to help you anticipate future interest rate changes and adjust your investment strategy accordingly.

4. Diversify your portfolio

Diversifying the portfolio by holding a variety of investments, including those of different maturities and sectors, can help reduce the risks associated with changing interest rates.

5. Have a long-term strategy

Interest rates can fluctuate over time. Having a long-term investment strategy can help you overcome short-term fluctuations and achieve your financial goals more consistently.

6. Keep track of central bank policy

Keep abreast of central bank decisions. Changes in monetary policy can have a major impact on interest rates and financial markets as a whole, and therefore on your investments.

Protect your assets with the help of Banco Carregosa

Uncertainty, especially with the constant influence of interest rates on financial strategies, is the only certainty in the world of investments. You can rely on Banco Carregosa to guide you through the complexities of the markets, maximise investment opportunities, make informed decisions and build a resilient and profitable portfolio. Contact us.