Types of interest rates and short-term outlook

July 2024 by Mario Pires

What are interest rates?

Interest rates are the cost of borrowing money or the return on investment. According to the Bank of Portugal, "interest is, in simplified terms, the price of money". Interest, as they explain it on their website, is "the price charged for a loan and the money earned on a deposit". In other words, interest is what you pay for the loan the bank gives you or the remuneration you receive from the bank when you put money in a deposit account." Interest rates, they continue, "indicate this cost or return as a percentage of the amount of the loan or deposit (a deposit corresponds to 'lending' your savings to the bank) and refer to a certain period, usually one year".

Rates can include the following:  

• Nominal and real interest rates
• Simple and compound interest rates
• Fixed and variable interest rates 
• Gross and net interest rates
• Nominal annual interest rate (NAR) 
• Annual percentage rate of charge (APR).
  

What happens when interest rates rise...

Interest rates can have an impact on investments at various levels. When rates rise, borrowing money can become more expensive.  

As far as bonds are concerned, as interest rates rise, the fixed interest payments on existing bonds look less attractive compared to new bonds offering higher rates. As a result, the prices of existing bonds tend to fall, negatively affecting bondholders.

There is also an effect on share prices: the higher the interest rates, the higher the borrowing costs for companies. This can reduce profitability and subsequently lower share prices. 

The best-known impact is on real estate: when interest rates rise, so do mortgage rates. This makes loans more expensive and can lead to a decrease in demand for real estate. As a result, property prices could fall, potentially affecting real estate investments.

On the other hand, higher interest rates can attract foreign investors looking for better returns. This increase in demand for the currency can lead to its appreciation, which can benefit investments denominated in that specific currency.

… and when do they come down?

Conversely, when interest rates fall, the opposite effect can occur. The impact of interest rate changes on investments can vary depending on the type of investment, market conditions and individual circumstances. 

There is also a type of interest rate that has stood out and which has been followed by the major economies. We're talking about the "neutral" interest rate. This is the interest rate that is (theoretically) neither too restrictive nor too broad, where growth and inflation return (in theory) to stable and predictable trajectories.

The European Central Bank has started to cut interest rates and, with the US Federal Reserve and the Bank of England about to follow suit, attention is turning to this "neutral" rate. 

The effect of inflation

The ECB's staff projections for inflation have been revised upwards for this year and for 2025, indicating confidence in the effectiveness of policy measures to achieve the target inflation rate. ECB President Christine Lagarde explained that although interest rates have been cut, they are still considered restrictive and will probably be cut further over the course of the year, even if inflation remains somewhat high. She attributed the persistence of inflation to a catch-up effect on wages from previous price increases, which is now leading service companies to raise their prices. However, early indicators suggest that wage growth is stabilizing and that companies are not fully passing on the cost of wage increases, which indicates that inflation should be moderate.

According to a Reuters poll conducted before the decision, economists expect the ECB to cut rates twice more by the end of this year and three times in 2025. However, investors are more cautious, as prices based on overnight index swaps suggest that fewer rate cuts are expected. Schroders, on the other hand, predicts three more cuts this year and two next year, which indicates a more optimistic outlook. This could have positive implications for the European fixed income and equity markets, supporting greater economic growth and lower discount rates.