How interest rates affect your investments

Most of us start our relationship with interest rates when we decide to take out a bond to buy property. When we go to our bank to ask for a loan, many questions are asked and eventually the bank will offer us a loan linked to something called the prime rate. If we ask the bank what the prime rate refers to, they will tell us that they have to borrow money from the South African Reserve Bank (SARB) at something called the repo rate, and after adding around 3% which is their profit margin, loan that money to us to buy the property. Currently the repo rate is 8.25% and the prime rate is 11.75% in South Africa.

If we do the calculations of how much interest we will have to pay over the 20 years of the bond, we very quickly realize how much money we can save if the interest rate we pay is a little bit lower. Sometimes a very small decrease in the rate can make the difference between being able to buy the property, or having to wait or buy something cheaper. If we think about this situation for a little bit we quickly realize that the manipulation of the interest rate does not come from our bank, but from the SARB, and that this ability to manipulate the interest rates provide governments with the ability to increase or decrease economic activity throughout the world.

The next question we can ask, is why it is important for governments to be able to increase or decrease economic activity. Once again we have to go back to the role of the central banks across the world (like our SARB), and realize that their mandate usually stipulates that they have to ensure price stability (inflation) and/or economic growth. The difficult part is that if you have very robust economic growth in a country, you also tend to get inflation, which will deteriorate the purchasing power of your currency if left unchecked. So when inflation starts going up, central banks will increase the interest rates, which will slow down economic activity and inflation will come down. The inverse also applies.

One of the side effects of changing interest rates is the impact it has on your investments. Shares, for example, are valued by using the interest rate set by governments. The higher the interest rate, the lower the value of the share and vice versa. If we look at what happened in 2022, we saw interest rates all over the world going up, and the value of shares going down. Towards the middle of 2023 it was clear that inflation was going to stabilize and that central banks would be in a position to lower interest rates in 2024, and share prices started to improve. We have to understand that it is not the interest rate that determines the price of a share, but rather the impact the interest rate will have on the potential for the company to generate income in future. But to keep it simple, the link between interest rates and the price of a share is very close.

The same effect can be seen in the valuation of bonds. If interest rates go up, bond prices tend to fall. One of the reasons is that you can get a competitive price in the bank or in a money market fund without the risk of the bond issuer defaulting on the bond. Once again we can look at the bad returns we saw in bonds during 2022. The good news to all equity and bond investors is that interest rates will be coming down soon and that this downward cycle could last for a couple of years. Equity and bond prices will benefit from these decreases owing to better economic activity (company earnings) and the basis for share valuations.

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