Blog Information

• Posted By : Bella Willow
• Posted On : May 17, 2024
• Views : 38
• Category : Education
• Description : The rise in interest rates causes shock in the entire stock market. When interest rates are high, borrowing costs also rise for both individuals and businesses.
• Location : United States

Overview

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  Introduction

  The rise in interest rates causes shock in the entire stock market. When interest rates are high, borrowing costs also rise for both individuals and businesses. Consequently, the higher interest rates requires cautiousness when making an investment decision. This translates into lower spending at the consumer and business level. However, not all businesses suffer from increased interest rates. Businesses such as banks, brokerage firms, and insurance companies generally continue to benefit from the rise in interest rates. As such, in case the interest rates rise, these financial sectors have the ability to increase investor returns. Consequently, when making an investment decision, it is important for an investor to select an investment that will lead to the desired outcome. This may sometimes diverge from the norm of investing in large companies that have a safe dividend division despite relative change in the nature of the economy.

  Theoretical Background

  Some of the scholars believe that the best stocks to purchase when interest rates rise are bank stocks. The argument is based on the premise that as interests go up, banks gain more money. According to Bikker and Vervliet (2017), low interest rate environments result in decreased profitability ratios of the banks. This view is supported by the fact that low interest rates negatively affect financial institutions such as banks due to decreased profitability. This is because banks are unable to utilize the traditional lending or funding practices that generate income as margins are minimized by the relatively lower interest rates (Bloomenthal, 2018). On the other hand, increased interest rates indicate a growing economy, which facilitates growth in both production and activities. In such economic times, consumers are often financially active, and they spend more. The ultimate result is that banks are able to explore businesses and make extra income (Horstmeyer, 2018). This arises from the fact that in a prospering economic environment, individuals pay their loans, which enables banks to benefit from fewer non-performing investments. Furthermore, the banks earn more from highly rated debts.

  Data Analysis

  In the USA, the Federal Reserve plays a central role in the determination of interest rates. After the onset of the 2007-2009 economic crisis, the central banks around the world began to significantly reduce the interest rates and buy assets within the open market in order to increase monetary supply and induce increased investment activities. However, the Fed is currently undertaking the process of normalization, which focuses on increasing short-term interest loans and reducing treasury obligations and securities held by the Federal Reserve in the form of mortgages. This has seen the interest rate increase from 0-2% in 2008 to above 3.25% recently in the country (Shell, 2018). Consequently, the banks have seen an increase in net income interest. For instance, JPM reported a quarter income interest of $13.6 billion.

  On the other hand, because of a surge in treasury bonds in May 2013, the MBS index of the Barclays bank rose from 2.6% to 4.5% within one month. Furthermore, since 2008, the increased interest rates have contributed to the growth of the US banking sector as compared to the world economies. As of 2014, the banking sector in the US was ranked the third largest credit provider around the globe after Japan and the U.K (“Recent trends in the U.S. banking sector,” 2014). Furthermore, the three largest banks in the US have shown increased profits. According to the statistics, JPMorgan profits rose by 25%, Citigroup Inc. by 12%, and Fargo &Co by 32% (Henry & Moise, 2018). As such, the low interest rates adopted during the financial crisis in 2008 resulted in pressure on interest margins of majority of banks within the US. However, the Fed’s increase in the rates of interest has seen the margin net in interest increase from a record low of 2.95% in the first quarter of 2015 to 3.30% in the second quarter of 2018 (Team, 2018). Consequently, the increased interest rates have seen the banks in the US accrue more profit and thus thrive amid the continuous interest rate increase by the Fed.

  The trend of the banking sector in the US with the onset of increased interest rates also mirrors that in other countries. A study by Yüksel, Mukhtarov, Mammadov, & Özsarı, (2018) on the profitability of the banking sector reveals similar results. The study has identified a positive relation between interest-related issues and bank profitability. Similarly, when interest rates rise, the risk rates will also rise due to pressures on equity dividend yields. According to the study, this varies between -0.255 and -0.327 (Yüksel, Mukhtarov, Mammadov, & Özsarı, 2018). As such, the banks should concentrate on issues and investments not centred on interest income. Furthermore, in the UK FTSE100 index, the shares of Royal Bank of Scotland have reduced by 32%, while those of Lloyds dropped by 25% because of announcements by Carney of intended cuts in interest rates (Treanor, 2016). Consequently, the reduced interest leads to a decrease in the banks’ profit margin, which makes the banks less willing to lend. On the other hand, the findings are consistent with the fact that banks in the UK are expected to make increased earnings of between 5%-6% if the Eurozone interest rates increase by at least 10 units (Noonan, 2017). However, banks exposed to the US market, such as UBS, benefit from the higher interest rates in the US.

  Conclusion

  It is true that making decisions on when and where to invest in the stock market is not an easy undertaking. This is because of the diverse factors that influence the stock prices. Although best stocks to purchase when interest rates rise are bank stocks, there are numerous associated risks that may make some investors resort to the conventional trend of investing in large companies’ stocks. Again, investors must understand that investing in the foreign economy could be challenging, but with Exchange Traded Funds, it is possible to invest in any country’s economy, however small that country is.