Interest Rates... What are they and How do they Affect Stocks?

Submitted by Marco on 30 June, 2006 - 21:40

The dictionary definition of "interest rate" is: the cost of borrowing money. The interest rate is often expressed as an annual percentage of the principal. There is more than meets the eye than just the one number. Interest rates are used by a country's national bank (Such as The Fed in the USA or the Reserve Bank of Australia or RBA) as part of their monetary policy to either stimulate growth or slow down the expansion of an economy. We will focus on the Australian side of the story in this article.

There are interest rates for different time horizons. There are short and long term interest rates. The shortest term interest rate is called the overnight or 'cash' rate. The RBA targets a specific rate which stands at 5.75 percent, by controlling the supply of money in the market. (Yes, go review your high school economics, supply and demand). Only the RBA can set this rate.

The dictionary definition of "interest rate" is: the cost of borrowing money.

Why are interest rates important? They impact everyone, either directly through loans or indirectly from rising prices. Since interest rates are the cost of borrowing, so any increase or decrease affects the level of investment as well as company bottom lines (depending on their gearing). So companies with heavy liabilities will need to service a larger interest payment. (Fundamental analysis tip: Do a search on highly geared companies. Look at their coverage ratio. Start with Newcrest Mning (NCM), PaperlinX (PPX), McGuigan Simeon (MGW) and Foster’s (FGL))

Here's another way to look at it. When you put money into a bank, you earn interest. This is the income your money is earning – the banks' payment for depositing your money with them, allowing them to lend out your money. At the moment you can earn just over 5 percent if you put your money into a bank. Keep in mind that this is a very low risk investment. Now any investment that yields above that say 10 percent will look attractive. Of course, with a higher return, you expect to have increased risk. Now, what if interest rates rise? Then, other investments will seem unattractive and their returns will need to rise proportionately. And this s across the board – with rising interest rates, all financial assets like property and stocks become relatively less attractive.

Now check your credit card or your mortgage. It's been reported earlier this year that Australians are heavily geared. This will of course hurt the hip pocket of consumers. Discretionary retailers as a result will hurt. Have a look at Brazin (BRZ), Strathfield Group (SRA), JB HiFi (JBH), Repco (RCL), Super Cheap Auto (SUL), while necessities like Telstra (TLS) and Woolies (WOW).

Because interest rate covers the cost of borrowing – it affects all companies listed on the Australian Stock Exchange (ASX) to varying degrees depending on their level of liabilities and perhaps their plans for future investment. One advanantage is that declining share prices as a result of a downturn from news interest rates gives many opportunities to buy into great companies.

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