Interest rates on the rise

This week saw the US Federal reserve increasing interest rates for the first time since 2018. This has been done to try to curb soaring inflation in the US. But what does this mean and how does this affect investors here in Jamaica?

Simply put, inflation is the general level of increase in the price of goods and services over a period. The higher the rate of inflation, the more rapidly the increase in prices. Therefore, having very high rates of inflation will negatively affect us (the consumer) as goods and services cost more and the rate of increase outpaces any increase in our individual earnings.

A person’s earnings can generally be deployed in 2 ways. Earnings can be spent on consuming products and services or can be saved/invested. When we receive our salary, we first look to purchase goods & services that are necessary for everyday living, our “needs”. The remaining portion can then be allocated to our “wants” or to saving & investing. In an environment where investors allocate greater portions of their earnings to purchasing goods and services, whether for wants or needs, there is increased demand for consumer goods as persons are spending more. With more funds being allocated to spending, the demand for goods and services outweighs the supply and will cause prices to increase. Price increases are not necessarily bad, but the rate of increase must be controlled to remain within an acceptable range.

To control the rate of inflation, the Federal Reserve has increased interest rates. In theory the increased interest rates will encourage more saving and investing than spending. More attractive interest rates will entice the consumer to allocate more of their earnings to saving than to spending, therefore reducing demand for goods and services. As more money goes to saving and less to spending, the rate of inflation or increase in prices should slow.

Slowing inflation is one effect of the move by the Federal Reserve. The increase in rates can also affect your investment portfolios. Many Jamaicans invest in global bonds which can be impacted by the rate increase.

There is an inverse relationship between interest rates and bond prices. As interest rates increase, bond prices decrease and vice versa. Bonds currently in issue will experience decreased prices as money moves away from the bond market and moves to US government issued securities. The reduced demand causes prices to decline. For bonds with low coupons, the effect may be even greater as investors will look to get out and invest in government securities (at a similar rate) or look for bonds with higher coupons. In the higher interest rate environment, new bond issues will have to offer higher interest rates than were being offered before the hike.

As we go through this rate hike, and the possibility of more to come, we must continue to stick to our investment plan. If you are currently invested in a bond, you. would have locked in your yield at purchase. Any price changes in the market will not affect your yields. They may reflect on paper as a loss, but the loss only materializes if you sell at that time. Once the bond issuer can meet its obligation by making interest payments and repaying principal at maturity, then the investor should continue hold their investment. Fluctuations can present opportunities to buy more of the bonds you currently own at attractive prices or buy new issues with attractive interest rates.

Dwayne Neil, MBA, is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at info@sterlingasset.net.jm.