Concepts

Economies and Currencies

Why the value of a country’s currency is related to the strength of its economy:

Global investors have a choice of where to invest their money and they will aim to invest it in countries that offer them the best chance to make money (obviously!). Typically, it’s easier to make money in an economy that’s growing: companies are probably going to sell more goods and/or services and their profits are more likely to increase. And so investors move investments into countries that are likely to do well (and less in one that is likely to do worse). In order to invest in a country, they must buy that country’s currency, which increases its value. Also, economies that are doing well are likely to see their interest rates go up (i.e., a central bank is much more likely to raise interest rates in a growing economy) – and that increases the value of the currency (see below for a fuller explanation of that).

 

How Interest Rates Affect Bonds and Stocks

The effect on bonds is relatively straightforward: if you think that you’ll get paid 5% interest next year but bonds right now only pay a 2% interest, then you’ll sell bonds right now and wait until next year to buy new ones… right?! :) That’s pretty much what happens: bonds that are currently in the market go down in price when interest rates look like they’re going up.

The effect on stocks is more complicated. For one, higher interest rates create somewhat of a headwind for the economy because it makes it more expensive for people and companies to borrow money (which they then spend on things). But this negative effect can be offset by an economy that grows strongly despite rising interest rates.

Another way that interest rates make it tougher for stocks is that they make bonds relatively more attractive. If you can get paid 5% per year for owning a government bond, you might choose to do that rather than choosing to own a supposedly riskier stock. So, investors on the whole tend to shift some money away from stocks (note: this happens after the bonds have sold off in price).

It’s important to remember that an environment in which interest rates are going up is not necessarily a bad one for stocks – it just can make things a little more difficult.

 

Interest Rates and Inflation

In theory, lower interest rates lead to higher prices by a) boosting economic activity and b) weakening the value of the dollar.

It boosts economic activity by making it cheaper for businesses and people to borrow money. That makes it cheaper for a business to build a new factory – and then buy equipment and hire workers for that factory. It also makes it cheaper for people to borrow money to buy a new home, which means that they’re more likely to go out and buy a new sofa and TV to fit out the home (also, existing homeowners might sell their home at the new high price and spend some of the money). Finally, investors can borrow more money too and they often take the borrowed money and buy stocks – and that increases lots of people’s wealth (and so people feel more comfortable about going out for that fancy dinner or buying a new laptop). The economic boost leads, eventually, to companies being able to raise their prices for their goods and services – and thus inflation goes up.

The second major effect of low interest rates on inflation relates to the value of the currency. When a country’s interest rate goes down, international investors are less willing to invest in that country (because they’re not getting paid as much in interest). And so, the value of that country’s currency goes down. In turn, it becomes more expensive to buy goods from other countries. For example, if the dollar goes down in value, olive oil that is made in Italy goes up in price for people in the US. And, thus, as prices go up, inflation goes up.

 

Inflation and Debt

Inflation is a way of reducing that debt, because inflation is, essentially, the rate at which the value of money erodes (rising inflation means €1.00 will buy you less over time). If one has a lot of debt, and the value of each euro is eroding, then the effective “value” of that debt is eroding – and it becomes easier to pay it off in the future.

 

How low interest rates weaken currencies:

You can lend money to one of the following two people:

  • A German is willing to pay you 0.5% per year in interest
  • An American willing to pay you 1% per year in interest

Who do you choose? Well, naturally you want to get paid the highest rate interest, so you’d choose the American. To do that, you have to first buy US dollars so that you can lend them to that American. If many people do that, that drives up the value of the dollar.

But what if interest rates change? What if all the money flooding into America has caused interest rates to fall significantly (money is like anything else – when there is too much supply, its price goes down – and its price is reflected by its interest rate)? Say, the picture now looks like this:

  • A German is willing to pay you 0.75% per year in interest
  • An American is only willing to pay you 0.25% per year in interest

Well, naturally, you’re going to make the American repay you (or, in reality, sell that “bond” on to someone else) and will sell dollars and buy Euros so that you are able to lend to the German. So the lower American interest rates pushed down the value of the dollar, and vice versa for Germany.

And that’s exactly how interest rates affect the value of currencies. Money likes to go where it gets the highest return and so, all else being equal, lower interest rates cause a currency’s value to decline.

*You’ll note we said “all else being equal.” That’s because there are other things that affect the value of a currency (like inflation).

 

Why deflation is bad

If prices are falling and things are getting cheaper, that should be a good thing, right?! Well, not really…

Falling prices, a.k.a. deflation, is akin to an economists’ worst nightmare (well, almost…). For one, it’s quite possible that the likelihood of prices falling further will cause people to delay making purchases… which leads to more price declines and more people holding off making purchases. The argument is probably too simple (people will keep buying food, for example) – but the point is that falling prices deter people from making purchases now, which hurts overall economic growth.

Perhaps more importantly, some inflation is necessary in an economy that relies to a large degree on people, companies and governments borrowing money (and virtually major economies rely on that). Inflation naturally erodes the value of debt (because that debt becomes progressively worth less with time and thus becomes easier to repay). In a highly indebted society, like the US, UK, Europe and Japan – a reasonable rate of inflation helps reduce that debt. That’s good because too much debt leads to decreased spending (if cash is being used to pay interest payments or pay back debt, there is less to be spent on economically productive things like hiring workers). And spending – on things like building factories, hiring workers or, even, just buying a toaster – is what drives economic growth.

Another corollary of that point is to think of the cost of holding onto cash. If inflation is high, the value of that cash gets eroded more quickly than if inflation is low – and so there is an incentive to “put that cash to work” by, for example, investing in building a new factory so that a better return is generated (and the value of that cash, net of inflation, grows). When inflation is low (or there is deflation), the motivation to put cash to work is diminished because the cost of holding onto that cash is so low. And so factories don’t get built and more workers aren’t hired – which is, of course, bad for the economy.

 

Markets and Inflation

Generally speaking, stock prices aren’t negatively affected by inflation because most companies should be able to raise prices in line with inflation over time. That kind of makes sense: if wages and other measures of inflation go up by, say, 2% per year then companies can probably raise their prices by about the same amount. This gets a little more complicated when we start considering what is driving the inflation and what types of things the company sells. If gas prices have jumped, for example, then people might be less willing to buy “discretionary” items like designer clothing as they are left with less cash in the wallets (because they are spending more at the pump). But if diapers go up in price because gas prices make the transport of diapers more expensive, parents will young children will be willing to pay up for diapers… and diaper prices rise as inflation goes up.

People that own investments that pay a fixed amount of interest (i.e. bonds) are the ones that are most harmed by inflation. That’s because increasing inflation is the same thing as the value of money eroding more quickly than it was before. And if you earn a fixed amount, say $50,000 per year, on your investments, then that money will buy you fewer goods and services as the inflation rate increases. And so, intuitively, the investments from which that income is derived should be worth less as the income is worth less (in terms of what you can buy with that income). And, in a nutshell, that’s why bonds perform poorly in an inflationary environment – they pay investors a fixed amount of interest that is gradually worth less as inflation increases.

 

Stocks and Currencies

Generally speaking, if a country’s currency is going up in value relative to other currencies, there is downward pressure on the value of stocks in that country (and vice versa).

There are a number of reasons for this. For one, if the dollar goes up in value, it becomes more expensive for international investors to buy American stocks and that decreases demand for US stocks (which exerts downward pressure on their value). Secondly, it becomes more difficult for American companies to sell goods overseas when the dollar goes up. Something that is produced in America will be, relatively, more expensive for, say, a European if the Euro has declined in value versus the dollar – and so American companies tend to sell fewer goods. Finally, profits made overseas are worth less when translated back to US dollars (i.e. a €100 profit is worth less in dollar terms as the dollar increases in value).

 

Quantitative Easing

Quantitative Easing (“QE”) is when a central bank directly buys its government bonds. The idea is that it’s enacted when a central bank’s target interest rate has already been cut close to zero. By directly buying government bonds, it decreases the yield those bonds pay (because when the price of a bond increases, its yield declines – see below). Many types of loans are based, directly or indirectly, on the yield of government bonds and so by depressing those yields, the central bank makes it cheaper for companies and people to borrow money than a low target interest rate would do on its own – and it’s hoped that the borrowed money will used to do things that boost the economy (like buying machinery or hiring workers).

Another impact of QE is that it encourages investors to buy riskier investments. If the returns available from government bonds are depressed to very low levels, then investors are more likely to seek out riskier investments (like stocks or property) that offer more compelling returns. That tends to boost prices, which feeds through to investors’ pockets and, in theory, can spur economic activity (e.g. if your house goes up a lot in value, you might feel more comfortable renovating the kitchen). For the same reason, QE has been criticized for increasing inequality in the sense that it arguably benefits those that already own things more than those that don’t.

 

Yield

When the price of a bond goes up, the yield of that bond goes down!

It’s actually pretty simple. Let’s say you’re getting paid $5 each year. If you pay $50 for that right, then you’re making a 10% “yield” (5/50 = 10%). But if you pay $100 for that right, then you’re making a 5% “yield” (5/100 = 5%). It’s the same thing with the price of a bond because the amount a bond investor gets paid (usually) is fixed. And so, when the bond goes up in value, the “yield” goes down – and vice versa.

 

Why does The Fed want to raise interest rates?

For one, it is wary of unnecessary stoking investment in riskier things, like loans to sketchy borrowers or excessive investment in real estate (if interest rates are extremely low, investors are more likely to seek out higher returns in riskier investments). In a similar vein, it doesn’t want inflation to go too high, too quickly (although this look like less of a risk at the moment) Also, the Fed has to essentially re-load on ammunition so that in the future, if/when the economy weakens again, it has the ability to decrease interest rates and give the economy a kick.

 

Why does the US Federal Reserve – and other central banks – aim for 2% inflation?

The Fed has two jobs: maximize employment and keep prices in the economy relatively stable. Obviously, inflation relates most closely to the latter objective. The Fed says that an inflation rate much greater than 2% would, over time, reduce the ability of people and companies to make long-term economic and financial decisions. The uncertain environment would likely, effectively, cause people and companies to spend less money – and the economy would suffer. On the other hand, inflation that’s well below 2% suggests the economy is doing poorly: people aren’t getting pay raises and there’s not enough demand in the economy for companies to raise prices, even modestly. So, 2% is judged to be just enough inflation to keep the economy from falling into deflation while not being so much that changes in prices become de-stabilizing and harmful.

 

Government borrowing and inflation

All else being equal, the more money a government borrows, the more likely it is that inflation in that country will increase in the future. That’s because the government will eventually have to pay back the money it’s borrowed. It can do this by either reducing its spending (expenses) and/or raising its taxes (income) so that it can afford to pay it back out of its annual budget – or it can print new money.

The first option, cutting spending or increasing taxes, is typically negative for the demand for money. Both of those measures create headwinds for the economy and thus reduce people’s and companies’ need for money (since demand for money is tied to wanting to invest or spend in an economy).

The other alternative, creating new money, increases the supply of money in the economy. There is simply more money available.

The value of money is just like anything else: when demand for it goes down and/or when the supply of it increases, its value falls (i.e. it can buy fewer goods/services). Of course, a decline in the value of money is the same thing as higher inflation – in both instances money buys fewer things. And thus, higher government borrowing eventually leads to the factors which erode the value of money – and increase inflation.