While interest rates are a useful tool for investment decisions, they are mainly used by the Central Bank in monetary policy. They can play a key role in the facilitation of money supply. Whilst the Central Bank can adjust money supply by buying or selling assets in exchange for more fiat (made out of thin air) currency, the adjustment of interest rates is seen as a more useful tool as it can be used to control inflation.
Why are Interest Rates so important?
Okay, when the Central Bank decides to print more money (as part of the monetary policy) it also has to create an appetite for the newly created money. It does so, or attempts to, by reducing the interest rates. This moves the money from the money investors (savers and institutional currency traders) to the asset investors. The banks are then incentivised by the lower rates to take on more risk. This, in turn, entices ventures to take out cheap loans for expansion and investment in long-term projects.
They use the new money to increase wages, hire more labour and make advancements in technology (which results in job cuts in the long run), and thence, increase the supply of goods. This increase in supply should be followed by a reduction in prices and fall in inflation, but because the growth is artificial, the laws of supply and demand are distorted. The end users have more money (albeit with a reduced purchasing power) to spend on the new supply (making the prices soar even more).
The adverse effects of this money expansion are not felt until the Central Bank contracts the money supply. Unemployment rises as a result of a dwindling money supply. Technology is favoured over manpower (job cuts are all the rage. A simple solution during quantitative easing is to cut hours – not jobs. Technology makes it easier to do monotonous tasks. Rather than cut jobs, employers should enforce shorter work days instead). This contraction in money supply (cheap money) also leads investors to abandon long-term projects as they realise they cannot afford to fund them.
There is also a huge supply/demand imbalance for goods and services because of unemployment and less disposable income available. This is what a recession looks like. Of course there are other external factors that affect the state of the economy (crude oil prices, for example), but the manipulation of interest rates is a major tool for controlling money supply and indeed, inflation. After all, the more money available, the more spending there will be. Right? Not so. This is the case for the global economy right now.
More and more “money” is being funnelled into the markets by the Central Banks (via stupidly low interest rates and quantitative easing) to raise inflation off the floor.
Despite this, the economy has seen no improvement in any area but rather there has been a rapid, uncontrolled rise in consumer debt and the “value” of the stock market (of course, the real value is diminishing, as is the purchasing power).
// More debt is being incurred on long-term projects, more expansion is taking place, but no significant improvement is seen. What is worse is we are now at the point where another recession is around the corner. Yet we are no better off now than in 2008! //
The inverse is true. When the Central Bank decides to contract money supply, it can do so by raising the interest rates (the cost of borrowing). This action deters investors from taking out loans and instead, returns their fiat currency to the bank in favour of the higher rates of return.
So if Interest Rates are Low, Isn’t Keeping Them Low a Good Thing?
Keeping rates low is not a good thing. While it is useful to grow the market, it is far better to allow the market to find its own sustainable levels of balance. By tampering with the money supply, the distortion of the markets must be maintained by (you guessed it) more manipulation. Artificial growth by means of low interest rates can only lead to one thing - “the boom and bust cycle”.
We are living in a bubble created by the Central Banks. Their Reserve notes have no backing whatsoever, and therefore, can be printed as seen fit. There is therefore no real growth in wages, employment or prosperity. What there is, however, is a growth in debt and a devaluation of currency.
As we know that the Central Bank charges an interest on the money it loans out, and the banks charge an interest on that money when they loan out. So answer this question – where does the money to pay the interest come from? Over 90% of the money supply is… wait for it… made up. It doesn’t exist. That’s why we see news headlines that read “Billions wiped off Company ABC’s value after poor profits report”. It is all a lie. That money was never there. If the money was backed by physical gold or silver, you couldn’t “wipe” it off!
So what do you think happens when the Central Bank asks for its money back? The government has to package more debt (in the form of bonds) and exchanges this for more “money” to pay for the debt already incurred. But that debt-acquired “money” is also charged at interest. So the government cannot physically afford to pay off its debt because debt is money and money is debt!
Okay, I Get It. So Rates Should Be Raised?
Well, yes and no. The raising of rates suggests that the economy is stronger and can cope with the increased costs of borrowing. But this, in itself, is a crippling concept when you consider that the only reason for the expansion of enterprise, the growth of the property market and the rise in employment and income, is the manipulation of the money supply in the first place! It is like a glass floor supporting the weight of the market. The market keeps bouncing higher and higher. But once the glass breaks… the only way is down.
What will happen (if rates are raised) is, money savers will start to move money back to the bank. They wish to gain enough interest to pay for goods and services in the future, rather than now (present and future value of money). The investors who have undertaken long-term projects run out of funding to feed the projects. The goods providers are left with surplus of labour and goods with no demand for them. And the cycle of boom and bust continues.
// The use of negative interest rates is to ensure that people do not save money. In theory, a negative interest rate, charges the banks for every monetary unit they hold in reserve. //
It is Not All Doom and Gloom
The one benefit of having a high interest rate is the interest from investors to exchange their capital for yours. Institutions that hold reserves for exchange flock to currencies with a high rate of return (New Zealand Dollar, for example). This allows them to achieve a higher yield on their investment when they swap currencies. After all, the higher the rate of return, the higher the interest accrued on the currency.
In the case of the New Zealand Dollar, the state of the economy has dwindled over the years since the last recession. Interest rates were set at 8.5% (one of the highest), but now linger at below 3%. This is of significance to currency traders who have and are (as is apparent from the charts) shying away from the Kiwi.
By trading currencies with low interest rates against those with higher interest rates, institutions can still benefit from rising rates without worrying too much about the effects on the economy.
Interest Rates and Bonds
Simply put, interest rates and bonds are inversely correlated. The reason behind this is logic. Bonds are fancy debt packages sold off as securities in the market. China is currently a huge owner of U.S. debt packaged as Treasury Notes. If the U.S. requires $1 billion, they sell $1 billion worth of bonds to China. China sends $1 billion in Federal Reserve notes to the U.S. But China isn’t doing this as a favour! China needs the U.S. to “prosper” so the U.S can continue to spend dollars on China’s exports.
When bond prices begin to fall, it shows a lack of demand for debt. If there are more willing sellers than there are buyers, prices fall. The reverse is also true.
So what happens when bond prices fall? The cause of prices falling is a lack of demand. This can be caused by a number of things. One of these causes is yield - the return on the investment. As interest rates begin to drop, the return on newly created bonds follows.
While prices for existing bonds are high, interest rates cannot be raised. There will be no demand for them. So the Central Banks watch out for demand of bonds. When prices for existing bonds reach levels where demand is sufficient, rates can be adjusted. The rise encourages more demand for newly created bonds at low prices, which in turn, causes prices to rise.
The notion of higher interest rates and a falling bond market causes the astute investors to sell bonds and buy them back when rates are higher. Cheaper bond prices at a higher rate of return, is what every bonds investor wants – because existing bonds are returned at par value.
What is Par Value?
Par Value is the issued price of a bond (gilt, in the U.K.). The par value of a bond is $1,000 in the U.S. and £100 in the U.K.
If the par value of a U.K. gilt is £100 (1-year maturity), and the current trading price is £90, the rate of return is 11% ((100-90)/90). But if the rates for newly issued gilts rise to 20%, the bonds currently having a yield of 11% are both not attractive and have no demand. Prices have to fall. The existing gilt price will be £83 to remain in demand.
If, however, rates were to fall, the existing gilts (10% return) become more attractive. More investors will opt to buy them and this will raise the prices of bonds.
Bonds prices are currently $1,280 and £118 in the U.S. and U.K. respectively. So what does this mean for investors? Buying existing bonds at these prices means that despite the fixed return on investments, you stand to lose money when the contract expires. The asking price of U.S. and U.K. bonds are currently 28% and 18% above par value. This means you lose 22% and 15% of your investment by cashing out of the market!
Interest rates play a huge role in the fate of the economy. Knowing how and when to use them to your advantage can be the key to success as a cash investor.