almost 3 years ago • 3 mins
Some investors hit the panic button last week when it seemed – if only for a moment – that interest rates might rise sooner than they expected.
✍️ Connecting The Dots
Here’s the key to understanding what’s been happening recently. In a growing economy, there’s rising demand for goods and services, which can lead to an increase in their prices – i.e. inflation. Central banks, meanwhile, keep a close eye on how quickly those prices are climbing. If they’re climbing too fast, that could discourage spending and have a detrimental effect on the economy. So that’s when central banks raise interest rates, which has a couple of effects: it effectively takes money out of the economy – cooling demand and, in turn, price rises – and it makes low-risk saving more rewarding.
That’s where financial markets come into play. If you’re now earning more from your savings in the bank, companies or governments borrowing money need to pay a higher interest rate for investors to justify putting their cash at risk. And if investors can make a higher return from bonds than they were previously, they’re likely to take money out of some of their riskier stocks and reallocate it to bonds. Enough of them do that at once, and the stock market gets knocked down a peg or two.
It’s worth noting none of this has actually happened yet: inflation’s still tepid and interest rates around the world are still at record lows. But just the thought of it happening tomorrow is enough to get investors who don’t want to be caught out to respond today. That’s what happened earlier this year: investors began anticipating higher inflation would spur central banks into action, and they sold off stocks in their droves. The ECB and Federal Reserve eventually calmed investors' nerves, but it didn’t exactly last: they were shaken up again last week when Janet Yellen said the US central bank might need to hike interest rates sooner than expected.
1. Short-term traders may have been burned by beta.
Some of the stocks that fell the hardest last week had a high “beta”, meaning they tend to rise more than the wider market in upward swings and fall more in downdrafts. Take Tesla: its beta is 2.09, meaning you’d expect Tesla to climb 20.9% when the US market as a whole rises 10%. On the flip side, you’d expect Tesla to fall 20.9% when the market drops 10%. You can easily find beta for a stock listed in the statistics tab of Yahoo Finance.
2. But long-term term investors barely noticed.
Here’s the thing about Janet Yellen: she was the former chair of the Federal Reserve (so knows a thing or two about central bank policy), but nowadays she’s the US Treasury Secretary. So like many of her predecessors, comments she makes about central banks don’t actually amount to much – especially when she quickly follows them up by clarifying that it was neither a prediction or a recommendation. And even if the central bank did listen to her, long-term investors are wise to the fact that there’s a long way to go before higher rates actually start hurting company profits – no matter when they arrive.
🎯 Also On Our Radar
According to the Federal Reserve’s latest financial stability report, measures of risk in the financial system might not be up to scratch. It pointed to the collapse of Archegos Capital as evidence that there are hidden vulnerabilities in the global financial system, and acknowledged that they could quickly be exposed if investors’ appetite for risk drops off.
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