On Thursday 3 November, the Bank of England’s Monetary Policy Committee voted to hike interest rates by 75 basis points. It’s the seventh time this year the UK’s central bank has increased borrowing costs.
While the media often talks about the impact of higher rates on mortgage holders and savers, the impact on the stock market typically receives less coverage.
So, how can rising borrowing costs impact investments? And with savings rates rising, is it time to move more of your portfolio into cash? Keep on reading for all the details or click on a link to head straight to a section…
The base rate: a quick explanation
The Bank of England base rate – also known as the ‘bank rate’ – refers to the interest rate that banks can borrow from each other.
In decade between the mid-90s to the mid 2000s, the base rate sat between 3.5% to 7.5%%. In other words, borrowing wasn’t cheap. Because of this, decent savings rates, high mortgage costs, and low-ish house prices were the norm.
Yet the 2008 financial crisis changed everything. The global economy was in turmoil, and Bank of England responded by wielding the axe to its base rate. Between February 2008 and August 2009, the base rate was chopped from 5.25% to just 0.25%.
For the following 14 years, interest rates remained under 1%. Yet, the tide is now turning…
Interest rates are rising, and rising fast. 2022 has therefore been a big wake up call for those with big debts. In November 2021, the base rate sat at an all-time low of 0.01%. It’s now 3%.
While some complain about rising interest rates, we should remember that the Bank of England has a target to keep inflation at 2%.
Hiking interest rates is the most effective way to tame inflation, which is why we shouldn’t be surprised at the Bank’s latest hike. Higher rates can also help support the pound against other global currencies.
How can rising interest rates impact the stock market?
As a general rule of thumb, when interest rates rise, stocks and shares suffer. This is mainly because rising rates can negatively impact businesses and consumers. Let’s dig a little deeper:
- The impact of rising rates on businesses. When interest rates are low, businesses can allocate more of their capital towards to investing in new projects, technologies, and/or staff. This is because when money is cheap, businesses don’t have to worry so much about the cost of servicing interest on loans. To put it another way, when rates are low, borrowing for the purposes of growth carries less risk.
However, when interest rates rise, the opposite happens. As borrowing becomes more expensive, businesses are more likely to take a risk-averse approach. For example, a business may be reluctant to invest in new technologies when borrowing costs rise. - The impact on consumers. When interest rates rise, savings rates will typically edge up. Because of this, consumers may be prefer to earn interest on their cash, rather than spend it. This can harm consumer demand for goods and services, which can impact business profits. Higher borrowing costs for business may also be passed on to consumers in the form of higher prices. This can also hamper consumer demand, as can the impact of higher rates for individuals. For example, if consumers are worried about their personal finances amid rising interest rates, there may be a strong temptation to cut back on non-essential spending.
The impact on the bond market
Bond yields rise when interest rates go up, which hits the value of bonds. This is because the risk-free rate of return on Government bonds increases when borrowing costs rise. In such an environment, new Government bond investors demand a greater return (or ‘coupon payment’) for lending to the state.
So, in the short-term, rising interest rates can negatively impact the value of a portfolio with a heavy holding of Government bonds. However, rising interest rates can actually help to boost bond returns in the long-term. This is because when rates rise, older bonds will be reinvested into new bonds paying higher yields.
Is it time to ditch investments?
If you’re seeing your portfolio slump thanks rising interest rates, you tempted to offload some of your investments and instead put your wealth into a normal savings account. After all, savings rates are rising like there’s no tomorrow.
However, it’s worth thinking very carefully before selling any investments right now. That’s because history has shown us that in the long-term, stock market returns have significantly outperformed cash held in a savings account.
This is a very important point to consider, especially as there isn’t a savings account out there that pays anything close to the rate of inflation.
JASMINE BIRTLES: CONSIDER A “MIXTURE OF OTHER ASSETS”
Money Magpie CEO, Jasmine Birtles, explains why investors shouldn’t rush to sell their investments right now.
“Rising interest rates are rarely good for stock markets. A lot of investors redirect their funds into savings accounts as they see the numbers rising. The belief is that savings accounts are safe so if they’re offering higher interest rates they are a better bet than ‘risky’ stocks and shares.
“However, with inflation at an official rate of 10.1%, savings account interest rates would need to quadruple in order even to just match inflation, let alone beat it. Admittedly, average stock market returns tend not to get into double figures, unless you’re in a good year, but all least they significantly beat average savings returns.”
Birtles also highlights the importance of investors thinking very carefully about their future returns.
She explains: “Personally I still don’t think it’s worth putting more than you have to put into savings accounts to be a decent safety net. Any money you’re looking to grow for the future needs to be in a mixture of other assets including stocks and shares, gold and possibly property.”
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Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.
