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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 so aim to invest it in countries that offer them the best chance to make money. Typically, it’s easier to make money in an economy that’s growing: companies are probably going to sell more goods and 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 those likely to do worse). In order to invest in a country, they must buy that country’s currency, which increases its value. Economies that are doing well are likely to see their interest rates go up – meaning that money in that country’s likely to earn a greater return by way of interest – and that, too, increases the value of the currency.

 

How Interest Rates Affect Bonds And Stocks

If investors think they’ll be paid 5% interest next year but bonds right now only pay 2% interest, they’ll sell bonds today and wait until next year to buy new ones. As a result, bonds that are currently in the market go down in price when interest rates look like they’re going up.

Higher interest rates make it more expensive for people and companies to borrow money (which they then spend on things), slowing down economic growth. But this negative effect can be offset by an economy that grows strongly despite rising rates.

Another consideration is that higher interest rates make new bonds appear a relatively more attractive investment compared to stocks. If investors can get paid 5% per year for owning a relatively safe government bond, they might choose to do that rather than choosing to own a stock – the value of which could fall, and has no guarantee of a return. So investors, on the whole, tend to shift some money away from stocks (after the bonds have sold off in price).

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 for some.

 

Interest Rates And Inflation

In theory, lower interest rates lead to higher prices by boosting economic activity and weakening the value of a country’s currency.

It boosts economic activity by making it cheaper for businesses and people to borrow money, thereby making it cheaper for a business to build a new factory – and then buy equipment and hire workers for that factory, for example. 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 a higher price and spend some of the money). The economic boost from higher demand leads, eventually, to companies being able to raise their prices for their goods and services – and thus inflation rises.

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 for that country to buy goods from abroad. For example, if the US dollar goes down in value, olive oil that is made in Italy goes up in price for people in the US. And so, as prices go up, inflation does too.

 

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 will buy less over time). If one (person or company) has a lot of debt, and the value of each dollar is eroding, then the effective “value” of that debt is shrinking – becoming easier to pay off in the future.

 

How Interest Rates Affect Currencies

If an investor can lend money to one of the following:

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

The choice is simple – to receive the most interest, they’d choose the American. To do that, they’d first  have to buy US dollars in order to lend them to the American. If several investors do that, it’ll drive up the value of the dollar.

Money is like anything else in that when there is too much supply, its price goes down (and its price is reflected by its interest rate). If all the money flooding into America causes interest rates to fall, the picture could look like this:

  • A German willing to pay 0.5% per year in interest
  • An American willing to pay 0.25% per year in interest

Investors, naturally, would want the American to pay them back (in reality, they’d sell that “bond” on to someone else), and sell those dollars and buy euros in order to lend to the German. Lower American interest rates effectively pushed down the value of the dollar, and vice versa for the euro, all else being equal (there are other things that affect the value of a currency, like inflation).

 

Why Deflation Is Bad

While prices are falling and things getting cheaper sounds good, actually it’s not that great…

When falling prices (a.k.a. deflation) takes hold, the likelihood of prices falling further might  cause people to delay making purchases. Those delays could lead to companies lowering prices to encourage customers to buy, which in turn might cause more people to hold off purchases. Of course, people won’t stop buying essentials like food, for example, but they’re likely to defer discretionary purchases, which weighs on economic growth.

Additionally, since virtually all major economies rely on people, companies and governments borrowing money, inflation is necessary. It erodes the value of debt over time, making it easier to repay. So in economies with lots of debt (like the US, UK, Europe and Japan), inflation helps reduce that debt. Too much debt leads to decreased spending (cash is being used to pay interest  rather than hiring workers, for example) on things like building factories, or just buying a toaster – which drives economic growth.

 

Markets And Inflation

Generally speaking, stock prices shouldn’t be negatively affected by inflation because most companies should be able to raise prices by at least as much as inflation over time. I.e. if wages go up by, 2% a year then companies can probably raise their prices by about the same amount. This varies, however, depending on what a company sells: if gas prices have jumped, for example, then people might be less willing to buy discretionary items like designer clothing as they’re forced to pay up at the pump. But if diapers go up in price too, because gas prices make their transport to stores more expensive, parents will still be willing to buy them.

Investors in assets that pay a fixed amount of interest (i.e. bonds) feel inflation’s pinch more. That’s because higher inflation means the value of money is eroding more quickly than it was before. If an investor earns a fixed amount, say $50,000 a year, from their investments, that money will buy fewer goods and services as inflation increases. And so it makes sense that the investments from which that income comes should be worth less, too – explaining why bonds perform poorly in an inflationary environment.

 

Stocks And Currencies

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

One reason for this is that if the value of the US dollar, for example, rises, it becomes more expensive for international investors to buy US stocks, and thereby decreases demand for them (which exerts downward pressure on their value). Another is that it becomes more difficult for US companies to sell goods overseas when the dollar is more valuable. Goods produced in the US will be, relatively, more expensive for a European if the euro has declined in value versus the dollar – and so US companies tend to sell fewer goods. Additionally, profits made overseas are worth less when translated back to US dollars – i.e. a €100 profit is worth less in dollars, the more the dollar increases in value.

 

Effects Of Quantitative Easing

Quantitative Easing (QE) is when a central bank directly buys its government bonds. The idea is that – when a central bank has already cut interest rates close to zero – directly buying government bonds decreases their yields those bonds pay. Several other loans’ interest rates are based on the yield of government bonds – so, by depressing those yields, the central bank makes it cheaper for companies and people to borrow money than a low interest rate alone would. It’s hoped that the borrowed money will be used to do things that boost the economy (like buying machinery or hiring workers).

Another impact of QE is that it could encourage investors to buy riskier investments. If the returns available from government bonds are low, then investors may be more likely to seek out riskier investments (like stocks) that offer higher potential returns. That tends to boost share prices, which feeds through to investors’ pockets – and, in theory, can spur economic activity. For the same reason, QE has been criticized for increasing inequality in the sense that it arguably benefits those that already own assets more than those that don’t.

 

Why Does The US Federal Reserve Want To Raise Interest Rates?

For one, it is wary of unnecessarily stoking investment in riskier things, like loans to high-risk borrowers or excessive investment in real estate (if interest rates are very 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. Additionally, the Fed has to essentially reload on interest rate ammunition so that when the economy weakens again, it has the ability to decrease interest rates and give the economy a boost.

 

Why Does The US Federal Reserve – And Other Central Banks – Aim For 2% Inflation?

The Fed has two jobs: to maximize employment and to keep prices in the economy relatively stable – and inflation relates most closely to the latter. The Fed says that an inflation rate much greater than 2% per year would, over time, reduce the ability of people and companies to make long-term economic and financial decisions. The speed of rising prices would likely 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. Central banks have therefore settled on 2% as just enough inflation to keep the economy from falling into deflation while not being so much that changes in prices become 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) – 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 slow economic growth and thus reduce people’s and companies’ need for money (since demand for money falls if people are less keen 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 rules of supply and demand apply to money as they do anything else: when demand for it goes down and/or when its supply increases, its value falls – i.e. it can buy fewer goods and services – which is exactly what happens to money when inflation is higher; they’re one and the same. Thus, higher government borrowing eventually creates the same circumstances erode the value of money – and increases inflation.

 

Trade War

Why do trade wars happen – and what impact do they have?

Trade wars can occur when countries start imposing barriers to trade (tariffs, for example) against each other. A country might do this to another in order to reduce its trade balance – the amount it spends on goods and services from abroad, relative to the amount it receives from selling its own products.

In 2017, the US spent $376 billion more on goods from China than vice versa. Reducing this figure would free up money for the country to spend elsewhere. The US buying fewer Chinese products is one way to go – and tariffs are another, since they raise additional money with which the government can spend elsewhere on growing the economy.

By making it more expensive for companies to get stuff they want from abroad, profits are likely to suffer – since costs are rising without being offset by either higher sales or lower costs elsewhere. Companies that try to pass their higher costs along to their customers might face falling sales if would-be customers are put off by higher prices and go elsewhere or decide not to make a purchase at all. This would feed through to lower profits – and likely falling share prices, as well as lower economic growth due to less demand for products. Longer-term a country would hope that any slowdown in economic growth can be offset by its own spending on the economy, using money collected from tariffs.

 

Why Companies Buy Back Shares

There are a few reasons a company might choose to buy back its own stock. It might believe its shares are undervalued by the market – and that its return on capital from buying them will be better than if it used the same money to buy machinery to build and sell more products, for example.

Additionally, stock buybacks usually create more demand for a company’s shares, since there are fewer of them available to buy – and can indicate that a company’s pretty confident in its future growth prospects (it probably wouldn’t buy its shares if it didn’t believe their value would rise in the future). So, to most investors, buybacks are a positive signal – and share prices of companies that announce buybacks usually rise. A more cynical interpretation, however, is that companies buy back shares in order to prop up their share price after bad news (by itself creating more demand for its stock as discussed).

 

Acquisitions And Stock Prices

When one company buys another, the share price of the company being bought (a.k.a. the target) usually rises – and that of the company doing the buying (a.k.a. the acquirer) usually falls.

The target’s price jumps because the acquirer usually has to pay more than the current share price – a premium – in order to take over the company: placing a high value on the target sweetens the deal for its investors who’ll likely make a tidy profit and are therefore likely to accept. The premium also partly reflects the buyer’s assessment of the company’s value when combined with its own organization.

The acquirer’s share price tends to fall if investors think its paid too much for the target – perhaps leaving less money for other things like investing in growth or paying a dividend – or if investors aren’t convinced it’ll be able to generate sales or cost synergies it may have promised. Acquiring companies comes with “execution risk” – the possibility things might not go according to plan. Systems, personnel, and culture can all clash when brought together, and any potential benefits from the partnership can be a long way off – or even found to be non-existent.

 

Buy The Rumor, Sell The Fact

Investors often look for an indication of what companies or central banks are likely to say before their official statements. These “rumors” can have an effect on the prices of assets as investors “buy” into them. When the actual announcement is made – i.e. the “facts” are out – investors who were right, having bought in ahead of any news may “sell” and take profits from any upwards price moves in the run-up to the release – hoping that other investors who’d also seen the news but not bought would be encouraged to buy as earlier investors sell.

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