Investing is a balancing act of weighing risks one against another. Most investors understand basic investment risk. They know, for example, if they invest in the latest startup, they could make a fortune by getting in on the ground floor, but they also risk their money if the company fails or turns out to be a scam. Other types of risk are political risk, currency risk, and inflation risk.
Inflation is when prices and wages rise weakening the value of money. Venezuelans are the latest victims of runaway inflation. Their money has so little value that people are weaving baskets out of the paper currency and trading the baskets for whatever they need. Consumer price index indicators (CPI) are a common way of measuring inflation, by calculating the purchasing power of a particular currency to a basket of regular consumer goods, or in Venezuela the basket itself.
Inflation is returning to US economy and this is a top concern for investors globally. Some inflation is healthy. Deflation, like what Japan experienced, is stagnating. They went through a prolonged period of extremely low-interest rates without growth. Normally low rates are stimulating, but companies in Japan were so heavily burdened they refused to take on more debt.
Rampant inflation is unhealthy and creates a great deal of instability in an economy and it falls on central banks to temper it. They use monetary policy to try to control interest rates and the pace of economic growth. One of the tools at their disposal is raising or lowering interest rates. The U.S. Federal Reserve had 3 raises in 2017 and another 3 are expected for 2018.
Changes in interest rate levels can be positive or negative, depending on your perspective. Retirees are generally happy whereas people buying their first home are not. Interest rate levels determine the cost of borrowing money.
When central banks inject liquidity into financial systems, it means more money is available at a lower price, and companies can expand and individuals can buy homes. When central banks tighten liquidity, there is less money available and the price rises. The price of borrowing money is the interest rate.
People are vulnerable to interest rate risk in an inflationary environment. The anticipation of rising interest rates creates instability and volatility in markets. In our current economic environment, economic indicators are strong and stock markets had solid gains in the past year.
There is a danger of things overheating and so central banks will do what they can to slow down the pace of growth and prevent things overheating and crashing, which they do by removing liquidity from the banking system, which raises rates and slows economic growth. Other times they will try to stimulate growth by making more money available and lowering borrowing costs.
As a general rule of thumb, lower interest rates are associated with rising stock markets, and interest hikes with market drops. Lower interest rates correlate with economic growth because they encourage business to borrow money and invest in their company’s growth. Lower costs of existing debt reduce expenses and improve earnings. They also reduce the costs of borrowing on margin so there is more buying which provides additional support to stock markets.
Looming threats of interest rate increases move markets as much as the raises themselves. Financial professionals from London to New York to Tokyo analyze every word, every change in tone of voice, every nuance when central bankers speak. In order to tamp down volatility, in the last few years, regulators have been more transparent and signal their intentions well ahead of taking action.
Wellington Capital Group is a wealth management firm based in central Tokyo. To find out more about protecting your capital from interest rate risk or to review your current holdings, please contact the office in Japan and ask to speak to an Investment Advisor.
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