Why You Should be Interested in Interest Rates
- James Martin 'student'
- Oct 26, 2021
- 3 min read
By: JT Martin
With interest rates being set near zero by the Fed during the beginning of the COVID-19 pandemic, they have nowhere to go but up. How would a rise in interest rates affect money managers and financial advisors? The answer may surprise you. The financial sector actually benefits the most from rising interest rates despite some of the effects it has on individual investors. Financials have seen the most benefit historically from rising interest rates because they typically signify a healthy and strengthening economy. This positive outlook on the economy would encourage more and more investing to take place, which is when companies in the financial sector make the most money. This is because, theoretically, rising interest rates show that the economy is healthy and therefore, people are making more money and can afford to borrow more, and the higher interest rate is still affordable, and because the economy is so healthy, they should then invest some of the money they borrowed. However, these benefits are primarily for financial institutions that do lots of lending since they get to lend at higher rates and receive higher profit margins by the nature of their business.
Today, many people are questioning whether the Fed should raise interest rates and if its effects will be beneficial to the economy. One reason people are concerned about this is that there is a lot of debate about the strength of the United States economy at the moment. Even though the stock market has fully recovered from the COVID-19 pandemic, unemployment issues and massive inflation concerns are present. The Fed has met many times to discuss these issues and has plans to taper their bond-buying program and expressed that interest rates will begin to rise soon. There is still much debate about what the Fed’s course of action will be that revolves around the permanence of inflationary concerns. Some say that this inflation is transitory, meaning temporary, and is just an outcome of the stimulus packages and supply chain issues due to the COVID-19 pandemic, while others say that these issues are persistent and have been shown in the rising commodity prices and consumer price index. These plans from the Fed are going to affect investors in many different ways. Despite the historical implications for the financial sector, I think a jump in interest rates will cause an immediate pullback in investor activity. Money has never been as easy to borrow as it was in the past year and a half; with the government stimulus programs and near-zero interest rates, money was being borrowed and spent so much that it led to a speedy economic recovery. However, investors have gotten used to the cost of borrowing being so low that a sudden rise will lead to a decrease in their disposable income and investing activity.
This pullback in investing activity will not be just from retail investors but also institutions. This is because large institutions like banks and investment banks now have a more expensive interest rate to borrow at. The stock market is then affected by this decrease in borrowing as companies have less capital available to grow and expand their businesses. This, paired with the reduction in investors’ disposable income, can cause a substantial drop in the stock market. Another way interest rates can affect the valuation of stocks is that as interest rates rise, the future cash flows of the companies are discounted at this new higher rate, which lowers the present value of the stock. However, a rise in interest rates doesn’t necessarily mean that the stock market will crash by any means. Still, if rates rise dramatically in a way that is unexpected to investors, then a sudden drop in stock prices could incite a massive selloff by investors that get worried by the fall in the market.
In my opinion, all of the attention that investors are giving to the Fed and their actions regarding interest rates and inflation has somewhat prepared many investors and money managers for a rise in interest rates well. While there will definitely be an initial reaction by the market when they do eventually rise, this preparation will keep investors calm enough not to create a dramatic and more permanent effect. The near-zero interest rates have helped spur the United States economy into one of the fastest rebounds we have seen, but as we continue to emerge from the pandemic and return to a strong and healthy economy, then interest rates can not continue to stay at near-zero forever. As inflation continues to rise and remain a concern, interest rates will absolutely rise at some point, but the real question is if the markets are ready for them to increase and if investors will react in a manageable way.
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