The Tech Selloff
As investors anticipate the inflationary aftermath of Covid-19 stimulus, they are selling out of risk assets as interest rates rise. The rapid rise in interest rates has spurred a sell off in growth stocks in the tech sector and a rotation into value stocks that are set to benefit from the reopening of the economy.
What are Interest Rates and What is Inflation?
Interest rates are an important metric for investors to keep an eye on as they impact consumer spending and the performance of stocks. An interest rate is the cost of borrowing someone else’s money, expressed as a percentage of the principal amount borrowed. The Interest rate stated on a loan or bond is known as the nominal rate which does not account for inflation. Because of inflation, the purchasing power of every dollar borrowed decreases over time. The real interest rate accounts for inflation by subtracting the expected inflation rate from the nominal interest rate. Interest rates are impacted by the demand and supply of money in the economy and actions taken by the federal government.
The Federal Funds Rate
The mandate of the Federal Reserve is to stabilize economic activity and help the economy prosper. One of the ways they do this is by controlling the Federal Funds Rate. The Federal Funds Rate is the interest rate at which banks lend each other money. When the Federal Reserve changes the interest rate on these loans, it sends a ripple effect through the economy. These loans help banks access cash which they use to lend out to institutions and consumers at higher rates. As banks profit from their loans to institutions and consumers, businesses get the capital needed to generate profits for shareholders and consumers get loans to buy houses, cars and other expensive items. These rate changes can have positive and negative effects on the stock market and overall economy. As the rates go down, companies have lower costs, allowing them to hire more people, which translates to higher consumer spending. Conversely, as interest rates increase it gets more difficult for firms to employ people and take on profit generating activities for their shareholders, which leads to unemployment and less consumer spending.
Why Not Keep Interest Rates Low?
When the economy is prospering from low interest rates, more people become employed and consequently consumer spending and demand increases. This causes companies to increase their prices and if this were to go on for too long, it would lead to inflation, meaning that the consumers purchasing power diminishes. We constantly experience low levels of inflation of around 2% every year. The further past this level that inflation rises, the more consumer wealth diminishes which could eventually lead to an economic crisis if left unregulated. When this happens Central banks increase interest which decreases demand in order to balance out inflation. Although this can lead to some short-term negative side effects like unemployment, lower profits for corporations, it ensures that we do not suffer an economic crisis.
Where Will Interest Rates Go?
Interest rates will certainly continue to dictate the direction of stocks. Whether they continue to rise, or fall is unknown. In either case, many investors are having a reality check and consequently readjusting their portfolios in preparation for the reopening of the economy and a consequent rotation out of growth and into value.