A lot of savers would jump up and dance if they heard that their interest rate is going up, but for traders this isn’t such good news. When the Central Bank announces that it’s going to increase the interest rates, the prices of stocks go down immediately. But how does this happen and why?
Interest rates go up, loans are more expensive
When the interest rate goes up, it becomes more expensive for both consumers and companies to borrow money. It’s more expensive to get a loan. Almost all companies have some kind of loan. They take out loans to invest or to leverage their profits. Consumers borrow money from time to time to make purchases.
Even the biggest companies borrow money. They don’t do this because they don’t have a lot of money, but because they can turn a profit on this line of credit. When you can profit about 7 percent on the capital within a company and you can get a loan for 5 percent, then every penny you borrow brings in more than it costs you.
When the interest goes up, this margin goes down, which means lower profits. When the (expected) profits go down, the prices of stocks also go down and most stockholders sell shares to keep their own capital secure. This makes the price of a stock go down.
Less investment and consumption
When loans get more expensive, companies can’t invest as much. Companies need money for expansions and innovations. When the interest rate for investments increases, companies have to scale back on their investments or even discontinue entire projects because there’s no line of credit available. Investments usually have a positive effect on the profitability of a company in the future.
A higher interest rate will also have an effect on the amount of spending. In the previous paragraph we talked about the effect on companies’ ability to invest. Companies have less money to invest and thus accomplish less. Consumers will also spend less because they don’t have the cheap loans they used to have to purchase goods and services. When purchasing power decreases, companies sell less. If sales decrease, this reduces the profits of these companies and in turn causes the price of their stock to drop.
Traders take their money off the exchange
When there’s an increase in interest rates, it’s more interesting to store your money in a savings account and it’s also more interesting to purchase bonds. It’s well known that these options are far less risky than trading. When the reward or the return of these instruments goes up, it’s logical response to sell your shares and store your funds in a savings account or use your funds to purchase bonds.
What do you do when the interest rate goes up?
A lot of people lock in the return they want to get annually. When the interest rate increases, the prices of stocks will go down while the return on saving accounts and bonds goes up. It’s recommended that you retract your funds from the stock market and put your money in the safest place. Especially because an increase in the interest rate can quickly cause the prices of stocks to decrease.
Of course there are ways to profit from an increasing interest rate. For example, you can go short using CFD’s or sprinters on the AEX-index. This way you receive money when the price of a stock goes down.