March 2018: Rising Interest Rates

The word inflation is regular topic now in the business news. Economic indicators show it’s gradually  rising in the United States which will have ripple effects throughout global markets. Inflation refers to an economic climate where prices are increasing and the value of money is falling. Low but positive rates of inflation reflect gradual economic growth and are healthy. However it gradually erodes the purchasing power of money, and reduces people’s standard of living. Hyperinflation, like Venezuelans are experiencing, is the monetary equivalent of a hurricane and is the worst scam a government can perpetrate on its people. At inflation levels reaching 4,000% people’s savings are wiped out and rendered valueless. Fortunately, these situations are rare in the modern world.

Deflation occurs when the money supply contracts, resulting in lower prices and increasing purchasing power.  This might sounds great for shoppers, but it reflects a slowdown in the economy and usually means a recession is starting. The Great Depression of the 1930’s is the most well-known example of deflation. A modern example would be the past 30 years in Japan.  Interest rates were at or below zero following a major housing crisis, yet for several reasons the country was unable to stimulate the economy using monetary policy. The last few quarters of statistics from Tokyo indicate that they are finally emerging from this stagnation.

SLOW AND STEADY WINS THE RACE

Economic growth is best when it is slow and steady. In order to keep a healthy pace, central banks use monetary policy to control their respective country’s money supply. In periods of recession, they inject cash into the economy and make borrowing cheaper by reducing interest rates, encouraging businesses and individuals to spend money. When the economy and the stock market are hot, central banks will tighten the money supply to cool things off. Tightening the money supply and raising interest rates will slow down an overheated market and head off a potential crash. The Federal Reserve in the United States raised interest rates three times last year, with the same anticipated for the balance of 2018.

INTEREST RATE RISK

Interest rate risk is the relative risk of how increases in interest rates will affect various investments. Asset management is a never ending series of decision making and trade-offs among different types of risk. If one is too conservative and assets are not growing enough, the investor faces inflation risk. If one is too aggressive and heavily weighted in high tech start-ups, they risk direct loss to online trading scams and business failure, for example.

Inflation and interest rate risk can trigger tremendous volatility in financial markets. Bond prices are negatively correlated to interest rates, especially bonds with longer durations and lower coupon rates. Higher interest rates affect the costs of borrowing money to buy stock on margin, which removes a certain amount of buying from the market as brokerage houses review their traders’ positions.

TIPS FOR MANAGEMENT OF INTEREST RATE RISK