Thursday, December 12, 2013

Understanding On Interest Rates and How It Impact Stock Market

A lot of people invest in stocks without giving much interest in interest rates. Same goes to me when I first started in the world of finance and economic. But don't worried, it's never too late to learn right? I know many people either the amateur or those who have many years investing experience left out this part. 

In this post, I wanted to give you a very brief introduction to interest rates and how it might impact on the market as well as your investment decision. 

Firstly, we need to understand what is interest rates. When you have your money place in a bank, the bank will gives you interest rate but this is not the interest rates we are talking about. 

The interest rates that many investment professionals or the medias referring to is the rate offered on overnight deposits by the central bank or any other banking institution. It is the rates that banks and other financial institution use to pay for borrowing and lending from one another. 

When a bank have access deposits, they can lend this money to another bank and thus the bank who borrowed will need to pay back the borrowed amount principle plus the interest rates. You can also look at it as the cost to the bank who borrow the money. 

Banks or any larger institution will always transfer money to each other, to foreign banks, to larger corporations on behalf of other clients or on their own accounts. 
At the end of the day, the bank will have surplus or deficit in the funds. The excess of money may be lend to or deposit with other bank in which will earn them on overnight rates. 

Now let's do a summary. 

1. Interest rates also known as overnight rates is controlled by central bank of a country. 

2. It is the rates that a bank either earn from their excess fund or pay if they need to borrow the fund. 

3. If a bank borrow from the other bank, the rates is considered a cost of borrowing to this bank. 

So.. How does all this brings impact to the market (money market, bond market, etc)

Lowering the rates means the bank now can borrow at a very low cost thus they will also lower the interest charged to the other retail or corporate borrowers. 

Imagine now you can buy a car or a real estate property at a very low cost (interest rates), it will encourage you to borrow thus if everyone borrow and put the money into real estate, stocks market, it will then create a short term boost to the economy. Companies now can borrow money to expand their business, graduates will be able to borrow to buy house or get married, etc. 

When people start to buy, demand will increase and this creating a inflationary effect to the market. Now supplier starts to sell at higher cost. There will also create a risk of an asset bubble when things go unreasonably expensive without any actual usage or demand to that particular asset. Think about a whole office building bought for the purpose of investment due to cheap borrowing cost but with less tenant or usage over the office building. 

Interest rates will also impact on bond market. Depending on the coupon rates of a bond, it will either increase or decrease in price on secondary market. But that maybe another chapter all together. 

So, central bank will always tend to use interest rates to balance off the economy as well as inflation. They want good economy growth by lowering down the rates but do not want the price to be too unreasonably high (inflation) so they will increase the rates. They call this monetary policy. 

So your take away in this chapter?

1. Interest rate will either increase or decrease cost of borrowing of borrowers. 

2. Lower interest rates means there will be a short term force or growth momentum to drives asset price up (real estate/ stock market) and the vise versa.

3. If you plan to invest into a market, do not go in when government increasing the rates. 

4.  All this are true only in a rational market but irrational will always tend to reverse certain theories. So keep an eye on irrational market (people are afraid to invest in stock market in 2008 with big institution declared bankrupt even through the interest rates is already low) 

Post your comments and ideas and let's make this a discussion subject. 
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