The Effect of an Interest Rate Increase

by Nicole Crawford

Interest rates are defined as "the cost of money that businesses and consumers alike must pay," as noted in "The Stock Market Course," by George A. Fontanills and Tom Gentile. It's no wonder, then, that high interest rates are disliked by consumers as well as businesses, due to to their economic effects.

Effects on the Dollar

Although the effect of interest rates on the dollar isn't always predictable, generally an increase in interest rates correlates with rises in the value of the dollar. As noted by Fontanills and Gentile, foreign investors are more likely to invest in markets that have a higher interest rate, since this will generate higher returns. However, if inflation is also high, then high interest rates may not be enough to attract foreign investors and increase the dollar's value.

Effects on Stocks

Although an interest rate increase doesn't have direct effects on stocks, it does affect them indirectly. As noted by Investopedia, increased interest rates have a ripple effect that gradually extends to stocks. Theoretically, stock prices will decrease when interest rates go up, since companies receive lower earnings due to decreased consumer spending. Also, because rising interest rates usually correspond with a slower economy, investors might not be as interested in investing in the stock market when rates are high.

Effects on Bonds

Generally speaking, interest rate increases correlate to drops in bond prices. However, several additional factors are at play, such as bond maturity and coupon rate. Bonds with a longer maturity period tend to decrease more when interest rates go up, and bonds with a lower coupon rate are more sensitive to interest fluctuations. However, if you hold on to your bond until it matures, you can avoid any decreases in bond prices, because you will receive the value of the bond and the interest accrued since its purchase.

Considerations

The effects of interest rate hikes may take quite some time to kick in. According to Investopedia, it usually takes about 12 months for more for changes in interest rates to really be felt in the economy. Keep in mind that although high interest rates may be a negative for people who need to borrow, they often work in your favor if your primary goal is to accumulate a savings, since you will generate higher capital.

About the Author

Nicole Crawford is a NASM-certified personal trainer, doula and pre/post-natal fitness specialist. She is studying to be a nutrition coach and RYT 200 yoga teacher. Nicole contributes regularly at Breaking Muscle and has also written for "Paleo Magazine," The Bump and Fit Bottomed Mamas.

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