General

How are interest rates set?

There are a number of factors that determine interest rates.

Interest rates can be influenced by the supply and demand for loans and credit, and are often lowered or increased on a short-term basis by central banks in an effort to stabilise economies. This, in turn, can have an impact on a wide range of areas including mortgages, borrowing, pensions and savings.

Central banks set short-term target interest rates that will directly impact what interest you earn when you save or are charged when you borrow. In the UK, the most important interest rate is the base rate which is set by the Bank of England’s monetary policy committee, which aims to keep inflation low and steady.

Central banks usually increase interest rates to raise the cost of borrowing and slow down economic activity and inflation. They will cut interest rates to achieve the opposite and stimulate growth.

While very short-term interest rates are set or heavily influenced by central banks, interest rate levels for longer maturities (e.g. 5 years or 10 years) fluctuate constantly to reflect supply and demand dynamics and, most importantly, expectations of central banks’ future decisions and growth and inflation outlook. The shorter the maturity, the more important central banks’ actions are in explaining interest rates. The longer, the more important other factors such as economic growth and inflation become.

What are central banks and what do they do?

A central bank is a financial institution responsible for managing a country or group of countries’ monetary policy. Central banks also oversee the monetary system through supervisory and regulatory powers and ensure financial stability. In most developed countries, they are independent from the government to prevent political interference.

The Bank of England is the UK’s central bank while in the USA, it is the US Federal Reserve, also known as the Fed. One of the key features of a central bank, which distinguishes it from other banks, is its legal monopoly status on issuing coins and banknotes, allowing it to increase the monetary supply.

Central banks’ primary goal is to maintain price stability by targeting a specific level of inflation over the medium term (2% in most developed countries). Sometimes, central banks also have a goal to maximise employment and act as a lender of last resort to distressed banks or financial institutions.

Central banks have three monetary policy tools to achieve these goals.

Firstly, they can increase or decrease short-term interest rates to either slow down or stimulate economic activity by making borrowing more or less expensive. When inflation is caused by excess demand, this tool can be effective at bringing inflation levels lower.

Secondly, they control money supply by buying and selling various financial instruments such as government and corporate bonds or foreign currencies. For example, an expansionary or ‘supportive’ policy means a central bank increases the amount of money in circulation by purchasing government debt – this is also known as ‘quantitative easing’.

Finally, they set reserve requirements, which stipulate how much money commercial banks need to have available for immediate withdrawal. Lowering the reserve requirements frees up some funds and allows banks to increase lending, which in turn should support economic activity.

What are equities?

To hold equities – through either the purchase or transfer of shares – is to own part of a company.

In return for increased financial performance by the company, the investor will receive a return or profit: either in the form of dividends, usually paid at set periods dependent on company performance, or via an increase in the share price.

Equities offer the potential for significant returns if the company exceeds the market’s expectations, but the value of shares can fall. Therefore, investment in stocks and shares requires an acceptance of investment risk.

Investment can be made in publicly listed companies or private companies. A publicly listed company is listed on a stock exchange.

A public company's market value, or market cap, is determined by multiplying a company’s number of existing shares by the value of a share i.e., a company that trades at £15 per share and has 1 million shares has a market value of £15,000,000.

What are ‘Gilts’?

A gilt or ‘gilt-edged security’ is a government bond. In the UK they are issued by HM Treasury and listed on the London Stock Exchange. The term gilt is also issued in India and other Commonwealth countries.

Typically, they have a very low risk of default and a corresponding low rate of return. This is because the British Government has never failed to make interest or principal payments on gilts as they fall due. Their name comes from the original certificates issued by the British government which had gilded edges.

The gilt market is comprised of two different types of securities – conventional gilts and index-linked gilts.

Conventional gilts are the simplest form of government bond. These types of gilts promise to pay a fixed coupon rate at set time intervals, such as every six months, until the maturity rate, at which point the holder receives the final coupon payment and the return of the principal. Conventional gilts represent the majority of government debt and about 75% of the gilt portfolio.

Index-linked gilts (IGs) represent bonds with borrowing rates and principal payments linked to changes in the inflation rate. This means that both the coupons and the principal paid on redemption of these gilts are adjusted to take account of accrued inflation since the gilt was first issued. They differ from conventional gilts in that the semi-annual coupon payments and the principal are adjusted in line with the UK Retail Prices Index (RPI). They form around 25% of the gilt portfolio.

Due to their low risk, gilt-edged bonds have yields that are well below those offered by more speculative bonds. As such, they are given a top rating by credit rating services such as Standard & Poor's and Moody's and often used by conservative investors whose top priority is capital preservation.

What are interest rates?

An interest rate tells you how high the cost of borrowing is or how high the rewards are for saving.

It is the amount a lender charges a borrower and is a percentage of the amount loaned. A borrower that is considered low risk by the lender may have a lower interest rate, while a borrower that is considered high risk may have a to pay a higher interest rate on the loan.

The interest rate on a loan is typically noted on an annual basis, known as the annual percentage rate (APR). The higher the percentage, the more the borrower must pay back for a loan of a given size.

If you’re a saver, the savings rate tells you how much money will be paid into your account, as a percentage of your savings. The higher the savings rate, the more will be paid into your account for a given sized deposit over a specific period of time.

The interest rate charged by banks is determined by several factors. In the UK, the Bank of England sets a ‘base rate’, and each bank uses it to determine the APR range they offer. When the central bank sets base interest rates at a high level the cost of debt rises. When the cost of debt is high, it discourages people from borrowing and can slow consumer demand. Interest rates can often rise in response to economic growth and inflation.

What are ‘Treasuries’?

Treasury securities, also known as Treasuries, are government bonds issued by the United States Treasury Department.

As they are backed by the credit of the US government and have the highest credit rating (AAA) of all debt securities, Treasuries are considered low risk. However, they can be impacted by inflation and changes in interest rates. They make twice yearly interest payments and are considered liquid, which means they can be converted easily into cash.

Treasuries are divided into three categories based on maturity date, Treasury Bills, Treasury Notes and Treasury Bonds.

Treasury bills (T-bills) mature in one year or less and do not pay a coupon rate so are known as zero-coupon bonds. Income is generated by issuing the bond at a discounted price compared to its face value, or par value.

Treasury notes (T-notes) on the other hand, mature in 2, 3, 5, 7, or 10 years and make coupon payments twice a year, either at a fixed or floating rate. The 10-year Treasury is the most notable Treasury as it is used when calculating the slope of the yield curve.

Treasury bonds (T-bonds) are the longest-term bonds and mature in 20 or 30 years. These typically offer the highest coupon payments but since bond prices are inversely linked to interest rates, these are also the most volatile Treasury.

Another type of Treasury is Treasury Inflation-Protected Securities (TIPS) which are indexed to the rate of inflation on a daily basis as measured by the Consumer Price Index (CPI). During periods of high inflation, the price of these bonds climbs, though subsequently the price falls when there is deflation. As with other Treasuries, TIPS also offer a coupon.

What does the Bank of England do?

The Bank of England (BoE) is the central bank of the United Kingdom. The BoE has several functions:

overseeing monetary policy
issuing currency and supervising payment services
regulating UK banks and other financial firms
maintaining a resilient UK financial system.

The BoE was initially founded in 1694 as a private bank to raise funds for the government. It began issuing bank notes in England and Wales in 1844 and was nationalised in 1946 following World War II. In 1997, the government transferred its authority over to the BoE’s Monetary Policy Committee (MPC) which then became responsible for setting the UK’s benchmark interest rate.

Today, the bank’s main objective is to manage the state of the economy and maintain price stability. It does this through its MPC, which has a primary mandate of keeping the annual inflation rate at 2% (as at January 2023). This 2% level is determined by the UK Government, but the BoE is independent in its decision making.

The MPC manages inflation by setting the core interest rate at which it lends to the banks, and by buying (or selling) assets. This process is called monetary policy.

The MPC convenes eight times a year to set rates. After a series of preliminary meetings, the committee's nine members vote on whether to increase, reduce or hold interest rates.

Increasing interest rates, also known as tightening monetary policy, is designed to reduce inflation by making borrowing more expensive, giving people less money to spend and therefore lowering demand. Antithetically, if the Bank cuts rates, also referred to as loosening or easing policy, borrowing becomes cheaper and people may be inclined to spend more, which in turn boosts the economy but can push prices up.

The Bank can also provide economic stimulus through asset purchases. This policy is known as quantitative easing (QE). Here the Bank purchases government bonds and other securities on the open market, providing banks with more liquidity, which further lowers interest rates and enables them to lend with easier terms.

What is a bond

Bonds are loans that can be bought and sold by investors. It’s important to note that a bond and a bond fund are two totally different investment vehicles - the focus here is on investment in a single bond. For an investor, a bond should be viewed as a loan, either to a government or a company.

In very plain terms, the borrower offers the investor an IOU, with the promise of repayment in full of the original loan after an agreed fixed period, called the maturity date, as well as periodic interest payments over the life of the bond.

Bonds are mainly split into two types: corporate bonds – issued by companies – and government bonds, for example, ‘gilts’ in the UK or US ‘treasuries’, which are long term investments, or US ‘T-bills’, which are short-term investment bonds issued for a year or less.

Governments across the globe issue bonds, with government bonds often referred to as sovereign bonds.

Bonds usually pay interest returns, also known as coupon rates, every six months or semi-annually.

So, an example of a coupon rate payment would be, where there is an expected annual coupon rate payment of 10% on the original investment, 5% of that annual rate would be received semi-annually.

Government bonds can be issued in their domestic currency or in a foreign currency. Government bonds issued in the domestic currency are less risky than corporate bonds. This is primarily because a country is very unlikely to default. A country’s government can more easily raise money through other borrowing sources or through taxation, but can also print money to pay debt obligations in their domestic currency.

Corporates however, can be at a higher risk of defaulting on paying investors coupons, or repaying investors original loans, because of potential market risk which could – for example – lead to a company becoming bankrupt.

For an investor this is called the default risk.

It’s therefore vital that corporate bond investors check the credit rating of a company before making their investment, via credit rating agencies such as Standard & Poor’s (S&P): Moody’s Investor Services (Moody’s) or Fitch IBCA (Fitch), as well as undertaking further company research.

The benefit of investing in corporate bonds is, generally, the higher coupon rate received due to a higher default risk than that associated with domestic currency government bonds.

What is a bond yield?

Bond yield is the return on capital you receive when you invest in a bond. The yield depends on both the price of the bond and the interest coupon paid on the bond.

However, the value of a bond – which is often referred to as the face value of the bond – can rise or fall dependent on market or economic conditions.

It’s important to note that the higher the value of a bond the lower the yield and vice-versa: bond yields are determined by dividing the coupon by the bond’s market price. Therefore, as a bond price increases, its yield falls.

Here is a straightforward example of how this works:

Taking a £1,000 bond investment with a 10 per cent yield (£100), let’s look at a scenario where the bond price has fallen to £950. If the bond sells today at £950 it is selling at a discount.

Therefore, the current yield is £100 divided by £950 = 0.105. As a percentage this would be 10.5 per cent.

Should the price of the bond increase to £1,050, the current yield becomes £100 divided by £1,050 = 0.095. Which as a percentage would be 9.5 percent.

What is a bond yield curve?

A bond yield curve effectively plots the interest rates paid to investors by bond issuers for different maturities. This applies to a range of bonds that have equal credit value but varying maturity dates.

We often come across ‘normal’ and ‘inverted’ yield curves.

Normal

A normal yield curve indicates the advantage of investing in a bond with a relatively longer maturity date. This form of curve is upward sloping. The majority of yield curves are upward sloping because investors demand a yield premium to lend money for longer periods of time, given the greater risk associated with this. Upward sloping yield curves also reflect investor expectations of steady economic growth.

Inverted:

An inverted yield curve is downward sloping, when short-term interest rates are higher than long-term interest rates. This is unusual but reflects an expectation that interests rates will be lower in the future, most likely as a result of a recession.

What is a circular economy?

A circular economy is a model of production and consumption that is based on three principles: eliminating waste and pollution; reusing products and materials; and regenerating nature.

It is a fundamental change in the way the world produces and consumes goods in order to tackle the global challenges of climate change, biodiversity loss, finite resources, and pollution.

To do this, the circular economy seeks to transform the current linear take-make-waste system by focusing on models of production where resources are kept in use and waste is minimised. This involves redesigning products to be more durable, repairable, reusable, and ultimately recyclable. It is a system underpinned by the transition to renewable energy and focused on regenerating nature.

An example of this in action is automotive manufacturer Groupe Renault, which in late 2020 established Europe’s first circular economy factory dedicated to mobility. Called Refactory, Renault aims to extend the life of its vehicles through remanufacturing components, increasing recycled plastic content, and creating a second life for electric batteries.

What is deflation?

Deflation occurs when the general price levels in an economy are falling – as opposed to inflation when prices rise.

It can be caused by an increase in productivity, a decrease in overall demand, or a decrease in the volume of credit in the economy. During deflation, the purchasing power of currency can rise over time. However, lower prices aren’t necessarily a good thing as the latter two cited reasons tend to signal a recession. For example, if the economy is slowing because interest rates and/or unemployment is rising, demand for goods and services declines, causing businesses to respond with price discounts in order to attract customers.

What is ‘ESG’?

ESG is a collective term that stands for environmental, social and governance. ESG are the variables in standards used to measure a business's impact on society, the environment, and how transparent and accountable its governance is.

The environmental standards measure how a company safeguards the environment through things like its corporate policies addressing climate change. The social criteria consider how the business manages its relationships with employees, suppliers, customers and the local community. Governance looks at a company’s leadership, executive pay, shareholder rights, internal controls, and audits.

ESG investing is used by socially conscious investors to screen investments based on corporate policies and to encourage companies to act responsibly. It can also help portfolios avoid holding companies engaged in risky or unethical practices and ensure businesses are held accountable.

What is fiscal policy?

Fiscal policy is the use of government spending and tax policies. These can influence economic conditions, especially macroeconomic conditions i.e., how markets, businesses, consumers, and governments behave.

These conditions take into consideration things like the aggregate demand for goods and services, employment, inflation, and economic growth.

Expansionary fiscal policy is largely based on the ideas of economist John Maynard Keynes (1883-1946) who argued economic recessions are due to a deficiency in consumer spending and business investment. Keynes therefore advocated for increased government spending and lower taxes to encourage demand and stimulate economic activity.

In contrast, to tackle inflation, the government can raise interest rates or cut spending to slow down the economy – known as contractionary fiscal policy.

Fiscal policy differs from monetary policy, which is typically enacted by central bankers rather than elected government officials.

What is GDP?

Gross domestic product or GDP is a measure of the size and health of a country’s economy over a specific period of time. It can be used to compare the size of different economies at various points in time.

In the UK, it is calculated each quarter using data from the Office of National Statistics (ONS). There are three ways to measure GDP:

Total value of goods and services produced (output)
Total income
Total expenditure

The figure will differ depending on the method of measurement as there is never enough data to build a complete picture of the economy. However, total expenditure is the most commonly used measure of GDP. It is the summation of household spending (around two thirds of GDP), investment, net exports and government spending.

Therefore, GDP can rise when people are spending more and businesses may be expanding. This signifies economic growth and is essentially a key measure of the overall strength of the economy.

GDP does not cover all economic activity, however. Unpaid work, such as volunteering or caring for relatives, and black-market activities are not included because they are difficult to measure and value.

What is inflation?

Inflation relates to the general increase in the prices of goods and services in an economy over time.

The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods, so inflation can be translated as a reduction in the purchasing power of money over time.

Typically, inflation is officially calculated based on the price of a whole range of items in a ‘basket’ of goods and services. In the UK, this is determined by the Office for National Statistics (ONS) who, every month, record the cost of over 700 things that people regularly buy. The basket includes everyday items, from a loaf of bread to a bus ticket, to much larger purchases like a car and a holiday.

The price of that basket tells us the overall price level. This is known as the Consumer Prices Index or CPI.

Inflation is conventionally quoted as an annual price change. To calculate the rate of inflation, the ONS compares the cost of the basket – the level of CPI – with what it was a year ago. The change in the price level over the year is the rate of inflation.

For example, if a bottle of milk costs £1 and that rises by 5p compared with a year earlier, then milk inflation is 5%.

A moderate level of inflation is healthy for the economy as it helps drive economic growth. Price stability allows consumers to make decisions with some level of certainty that inflation will not erode the value of money.

Inflation can be contrasted with deflation. Deflation occurs when inflation is negative, i.e. when prices decline over time. In this instance, purchasing power improves, meaning that your money can buy more goods and services.

What is macroeconomics?

Macroeconomics – often referred to simply as ‘macro’ – looks at the behaviour of an economy in aggregate. It examines economic trends such as inflation, economic growth, gross domestic product (GDP), employment and the labour market, and consumer and corporate behaviour.

The relationships between these factors are used by macroeconomists to develop models. These models, and the forecasts they produce, help governments evaluate how an economy is performing, and decide on the actions it can take to increase or slow growth through monetary and fiscal policy.

Businesses also use macroeconomic models to set strategies in domestic and global markets. Similarly, investors develop market cycle models that include macroeconomic variables, which guide investment decision making in different economic phases such as slowdown, recession, recovery and growth.

What is microeconomics?

Microeconomics is the study of how individuals, households and companies make decisions to allocate their resources. It normally applies to goods and services, markets, or individual finance.

Microeconomics focuses on responses to changes in incentives, prices, resources, and methods of production. It shows how and why different goods have different values, how individuals and businesses conduct and benefit from efficient production and exchange, and how individuals best coordinate and cooperate with one another.

Microeconomists formulate various types of models based on logic and observed human behaviour, and test them against real-world observations to allocate resources of production, exchange, and consumption.

Unlike macroeconomics, which involves the study of economy-wide aggregates, microeconomics deals with prices and production in single markets, and the interaction between different markets.

What is quantitative easing?

Quantitative easing (QE) is a form of monetary policy in which a central bank, such as the Bank of England, purchases government and corporate bonds from the open market to reduce interest rates and increase the money supply.

QE can be implemented when interest rates are near zero and economic growth has stalled to help prevent recession and deflation. Without the ability to lower interest rates further, central banks must strategically increase the supply of money through bond buying.

By buying these bonds, central banks increase the supply of money which in turn can lower the interest charged on borrowing. This provides liquidity to the banking system and enables banks to lend with easier terms, hopefully benefitting households and businesses.

QE was most notably used after the Global Financial Crisis that began in 2008. The Bank of England reacted by reducing the Bank Rate from 5% to 0.5% to help the UK economy recover. However, even with the rate that low, the Bank needed to do more to stimulate spending in the economy so turned to QE.

What is Stagflation?

Stagflation is essentially a portmanteau of economic stagnation and inflation. It is used to describe a period when economic growth has slowed dramatically, consumer prices are rapidly rising, and unemployment is relatively high.

There is no real consensus among economists as to the causes of stagflation, though it has been linked to a supply shock, an unexpected event that abruptly changes the supply of a commodity or product forcing prices up, or poor economic policy, such as making production more expensive in a high inflationary environment.

The most notable example of stagflation occurred during the oil crisis of the early 1970s when the Organization of Petroleum Exporting Countries (OPEC) embargoed oil exports to Western countries. This caused the global price of oil to rise dramatically, and the knock-on effect was a sharp rise in the cost of living, a slump in economic growth and high unemployment.

More recently, the war in Ukraine compounded the supply shocks caused by the Covid pandemic, pushing commodity prices up and magnifying the slowdown of the global economy. Some have argued that this created the foundations for a period of stagflation.

There is no simple cure for stagflation. Raising interest rates to counter inflation can depress growth, while the reverse risks pushing prices ever higher. Governments and central banks must strike a tricky balance between controlling inflation and the risk of wage price spirals and trying to stimulate growth through public spending, support packages or tax cuts. Ultimately, economists argue that productivity needs to increase to the point where it will lead to higher growth without additional inflation.

What is ‘The Fed’?

The US Federal Reserve, also known as the Fed, is the central bank of the United States, mandated to provide the country with a stable monetary and financial system.

It was established in 1913 by the Federal Reserve Act to prevent further economic disruptions such as bank failures and business bankruptcies following the financial crisis of 1907.

The Fed comprises 12 regional Federal Reserve Banks that are each responsible for a specific geographic area of the United States. Its duties include conducting national monetary policy; supervising and regulating banking institutions to protect consumers’ rights; maintaining the stability of the financial system; and providing financial services (which includes operating the national payments system and depository institutions).

The Fed is made up of a Board of Governors who are nominated by the President and approved by the US Senate. The governors are responsible for setting reserve requirements. This is the amount of money commercial banks are required to hold to ensure they have enough to meet sudden withdrawals. The Board of Governors also sets the discount rate, which is the interest rate the Fed charges on short-term loans to financial institutions. These discount loans are intended to be primarily an emergency option for banks in distress.

The Federal Open Market Committee (FOMC) is the Fed’s main monetary policymaking body. To set monetary policy, the committee directs open market operations (OMOs). This is the process of buying or selling US Treasuries, along with other securities, on the open market in order to manage the money supply. Through this the Fed can adjust the federal funds rate and therefore the amount of money and credit available in the economy.

What is the FTSE 100?

The FTSE 100 or the Financial Times Stock Exchange 100 is an index made up of shares from the 100 biggest companies by market capitalisation on the London Stock Exchange (LSE). These are usually referred to as ‘blue chip’ companies with the index viewed as a good indication of their performance.

Launched on 3 January 1984, the index is ever changing as company values change due to performance, mergers and acquisitions, and the rising and falling value of companies. A review is undertaken every quarter to make sure the FTSE 100 accurately reflects the 100 largest companies. Companies included in the index must be denominated in pounds and must meet minimum float and stock liquidity requirements. While the companies in the FTSE 100 are listed in the UK, many of them make their money overseas.

The FTSE 100 is calculated by weighing all stocks listed on the LSE by market capitalisation. The total market capitalisation is affected by the individual share prices of the companies and as their share prices change throughout the day, so does the value of the index. When the FTSE 100 is ‘up’ or ‘down’, the change is being quoted against the previous day’s closing price. Stocks with higher market caps have more weight in the FTSE 100 and therefore have a bigger effect on the index’s price movements.

The FTSE 100 is used as a measure of the UK’s stock market.

What is the FTSE 250?

The FTSE 250 is a mid-cap stock index comprising the 101^st to 350th largest companies listed on the London Stock Exchange. As a capitalisation-weighted index, like the FTSE 100, companies included in the FTSE 250 are based on the value of the shares they have in the market.

Established in 1992, the companies which make up the 250 are more domestically focused than those in the FTSE 100. Typically, more than half their sales are domestic compared to less than a quarter for FTSE 100 companies. As a result, the FTSE 250 is viewed by many investors as a better indicator of the overall UK economy.

What is the S&P 500

The S&P 500 Index is a stock market index that tracks the 500 leading publicly traded companies by market capitalisation in the United States. It is widely regarded to be one of the best gauges of overall American stock market performance as it captures the activity of around 80% of the market capitalization of all US stocks.

Launched in 1957 by credit rating agency Standard & Poor’s, the S&P 500 is a float-weighted index. This means the market capitalisations of the companies in the index are adjusted by the number of shares available for public trading, the free float.

To calculate the market cap of a company in the S&P 500, the current stock price is multiplied by the company's outstanding shares. As such, the value of the S&P 500 changes constantly throughout the trading day based on the movements of these company valuations.

One drawback of the S&P 500 being float-adjusted is that the index is weighted in favour of large-cap companies, meaning these stocks can have an outsized impact on the index. However, it is still considered more representative of the total stock market than narrower price weighted indices like the Dow Jones.