Interest Rates and Investments
Over the long term, it is possible to amass hundreds of thousands, if not millions of dollars, through smart investment decisions. Savers generally look towards financial markets to help themselves provide for start-up business costs, four-year college tuition payments, and ultimately, a retirement lifestyle. As part of this wealth creation process, it is critical that savers understand how prevailing interest rates affect different asset classes. From there, Onyx Investments can best help its clientele to put together an investment portfolio that suits their savings objectives.
Federal Reserve Board
The Federal Reserve Board influences the domestic economy through its management of the prevailing interest rate environment. To do so, the Federal Reserve Board sets a target federal funds rate, which is a benchmark for all other interest rates. Banks borrow money from each other overnight at the federal funds rate to meet their Federal Reserve requirements. For consumer loans, banks then charge a premium rate above the federal funds rate as compensation for taking on the added default risks. In recession, the Federal Reserve lowers interest rates to encourage investors to take out loans, invest and spend money, which should stimulate the economy. When the economy recovers, the Fed will drive rates higher to guard against inflation. Higher rates act to slow down the economy, as capital then generally flows into fixed-income securities.
Money Market Securities
A money market asset is actually a credit security, or loan, that matures in less than one year. Individual money market securities include commercial paper and treasury bills. Smaller investors, however, may buy into money market mutual funds, which are actually large pools of individual securities. Because of their relatively short durations, returns on money market funds and securities closely track the federal funds rate. Money market funds therefore offer higher returns as the Fed targets higher interest rates amid improving economies.
Fixed Income Securities
Fixed income securities, such as bonds and preferred shares, pay out a level amount of investment income throughout their term. In terms of returns, these assets feature an inverse relationship to prevailing interest rates. When interest rates move higher, new fixed income securities will offer relatively higher amounts of investment income. At that point, existing fixed income securities will sell for a discount, because they then provide relatively low interest and dividend payments. Existing fixed income securities actually perform well as interest rates decline. In this environment, existing bonds and preferred shares will gain value because they then offer relatively high amounts of investment income, in comparison to the freshly issued securities.
Stock Market Investments
Shares of stock represent ownership claims within publicly traded corporations. As ownership stakes, share prices fluctuate alongside corporate profits. Lower interest rates reduce corporate borrowing costs, which should translate into improved business profits and share prices. Low interest rates also encourage investors to take on stock market risks, because competing money market and cash deposits then offer minimal returns. Alternatively, higher interest rates are usually a leading indicator for future stock market losses. High interest rates increase corporate borrowing costs, and may influence traders to take money out of the stock market in favor of bank deposits and bonds.