Interest Rates Drive the Financial Markets

Economists, financial analysts and investors watch the interest rates of each country with keen interest. One professor once said that if a person can predict the future interest rate accurately, he could make millions! That is why the obsession by the finance community in studying the statements made by the US Federal Reserve Board (FED) Chairman, Bank of Japan (BOJ) Governor, European Central Bank (ECB) President.

The latest news on the BOJ raising Japan’s main interest rate by 0.25% to 0.5% drew analysis by Economic Correspondent Erica Tay (The Straits Times, 22 February 2007). This rise in interest rate has already been anticipated by the financial community and already factored in the stock market, bond market and the yen foreign exchange rates vis-à-vis other currencies.

In theory, when the interest rate of Japan rises, its yen currency should strengthen. This is for reason that there is demand for yen to capitalise on the yen-denominated investment assets at higher interest rates. However, this is not the case now as Japan is flush with liquidity funded by cheap yen loans. The supply of yen is high relative to the demand for yen. Where the supply and the demand curves of yen intersect, the currency rate is then determined. Erica Tay wrote that for several years, investors worldwide have been taking advantage of lowest borrowing costs in the developed world, and borrowing in yen to invest in high-yielding assets such as Australian bonds or Asian stocks. This practice is known as the yen carry trade.

The interest rate of Japan is still low when compared with United States at 5.25%, or the euro zone at 3.5%. (Reuters, 22 February 2007) The wide gap in rates has encouraged investors to sell yen in recent months in favour of the US dollar or the euro.

A country will adjust interest rate based on the state of the economy at that time and the rate of inflation faced by the country. Should there be overheating or an asset bubble is building up, it is more than likely that the country’s central bank will raise interest rate so as to cut off easy credit in the economy. With high interest rate, the country’s currency will strengthen against others, thus import inflation remains low. The export becomes expensive thus choking off untenable investments or over-trading.

If you are an investor, take note that when interest rate goes up, the bond price will come down. This is an inverse relationship. The stock market valuation will also come down because it is now more expensive to borrow and invest in the stock market. Another reason is also that the corporations will have higher borrowing costs thus reducing their profits. This leads to lower stock prices of the corporations.

It therefore pays to read news on interest rates of various key countries including Singapore’s.

Written on 2/22/2007 3:28 PM

Copyright © 2007, the author known as LKT in Singapore.

The material presented is intended to be general and written in layman’s language as much as it is possible. The author shall not be liable for any direct or consequential loss arising from any use of material written. Please seek professional advice from your financial advisor or financial institutions on material written covering financial matters.

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