2 Aug 2023

How Should You Respond

to Rising Interest Rates?

What are interest rates?

Interest rates are the cost of borrowing money or the return on investment for lending money. Interest rates play a crucial role in the economy and financial markets as they influence borrowing and spending behaviour, investment decisions and overall economic activity.

The Bank of England uses interest rates as a tool to manage monetary policy and stabilise the economy. It sets a target to keep inflation at 2 per cent per annum, however the current rate is 7.9 per cent. Lowering interest rates can stimulate borrowing and spending, while raising interest rates can help control inflation and prevent excessive borrowing, slowing the economy.

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Where are interest rates at now?

Interest rates in the UK currently stand at 5 per cent and are likely to carry on rising until it becomes clear to the Bank of England that inflation is falling. Soaring food and energy bills have helped drive inflation up in recent years, particularly since the Russian invasion of Ukraine in February 2022. 

Because interest rates are one of the only levers the government currently has when it comes to controlling inflation, it will probably take even higher interest rates to bring inflation firmly back under control. 

What are the effects of rising interest rates?

Rising interest rates can have significant effects on various aspects of the economy and personal finances. As interest rates rise, the cost of borrowing money increases. Increased borrowing costs can also lead to reduced consumer spending. Importantly for the government, higher interest rates can help reduce consumer spending and cool down the economy, leading to lower inflation rates over time. This is the stated aim of current interest rate hikes.  

The housing market is particularly sensitive to interest rate changes. Mortgage rates have risen sharply in recent times. However, most people with a mortgage in the UK are on a fixed rate, meaning they won’t be directly affected by rising interest rates, until the end of their fixed term.

In which direction are interest rates likely to go?

Up. At least for now. Financial markets expect the Bank of England to increase the base rate again on 3 August. Rising interest rates are all about expectations – and in particular, expectations of which direction inflation is going. Once inflation falls closer to the Bank of England’s 2 per cent benchmark, interest rates will begin to plateau. Markets will then take this as a signal that we’ve reached the end of this interest rate rising cycle and valuations of most other assets (apart from property, which is likely to stagnate) will start to go back up again. 

Should rising interest rates affect where you put your money?

Markets function on the basis of expectations. They are always looking 12 to 18 months ahead. They are currently jittery about the state of economy in 2024; however this doesn’t mean that investment returns will necessarily be bad in a year or 18 months from now. On the contrary. There is a good chance that, on those timelines, things will look very different to the way they look now.

Once interest rates begin to level off, markets are likely to go back up again. This is why it is probably a mistake to chase interest rates today by taking money out of an investment portfolio and putting it into a cash savings account. By doing this you will have gone through all the pain and the hard yards over the last few years – only to bail out before you enjoy the gains that come with improved market conditions.

Sometimes it’s difficult not to be spooked by market volatility. But when considering what to do with your current investments, it’s important [as Howard Marks writes for the FT] to ‘recognise when people are so depressed that they conclude things can only get worse, as this often means they think a sale at any price is a good sale’. 

Here at FiveWays we try to avoid the temptation of short-term thinking. Past experience has taught us that riding out the market’s jitters can often be the best course of action when it comes to making meaningful gains over the longer term.

Are you unsure about any of the interest rate changes?

Feel free to contact one of our specialist advisors to talk things through if you want further advice about interest rates or if you would like to talk through your investment options.

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