In this week’s post I will be focusing on the increase in interest rates that has just been announced by the US Federal reserve which is the central bank of the USA. The Fed increased its base rate from the current 0%-0.25% range to a 0.25%-0.50% range. For 7 years we had witnessed a near 0% base rate making money cheap to borrow. The post will aim to focus on how this affects Malta and the broader Euroland countries. I will first be focusing on the effects of an interest rate rise in general and then move on to focus more on how we as Maltese and other countries that use the Euro as their main currency will be affected. Should we care about what the US is doing?

First, some basic economics to help you understand better the rational for manipulating interest rates. Having low interest rates is expected to lead to cheap money that would in turn cause consumption and private sector investment to go up which would lead to a higher gross domestic product. In simpler terms this means that if households and business can borrow at cheaper rates they would be more inclined to do so. When they have access to the cheaper funds they will spend more, for example on new housing or on building a new factory. In turn this will generate more income for other economic participants and everyone is better off.

On the other hand, if too much money is present in the economy this will lead to a general increase in prices, or inflation. Thus, in order to avoid having too much inflation the central banks can increase interest rates in order to reduce spending and private investment – in technical words they would be tightening. It must be kept in mind that in the real world things are not as simple as I have just described since there are undoubtedly a lot of variables being affected at once. The following video is great to help understand better how the Fed manipulates interest rates:

Who Wins When Interest Rates Go Up?

1. Banks

The obvious winners as a result of increased interest rates are of course the banks. For a traditional bank that is mainly concerned with taking deposits and making loans their bread-and-butter is their Net Interest Margin (NIM). This is simply the difference between how much the bank is earning from the interest rates on its loans and how much it is paying in interest rates on its deposits. So if interest rates go up the banks can start increasing the interest rates they charge on their loans and this will lead to increased income for the bank.

2. Insurance Companies

Insurance companies typically invest their money in fixed income assets such as bonds from the higher quality end of the market. As any fixed income investors knows the yields on bonds has been low for quite a while now and hence the income insurance companies can earn on their investment will increase as interest rates go up. Of course there exists the other side to this argument that as interest rates go up the prices of bonds will go down and thus insurance companies would suffer in terms of the value of their capital. Although this is true, one must keep in mind that insurance business is long term business. So if the insurance company has bought bonds with the intention of holding them until maturity, the price drop experienced before maturity does not really affect them. Such companies would use a combination of strategies such as keeping a portion of the portfolio in short dated bonds which would be less affected by interest rates rising.

3. The US Dollar

In simple terms since the interest rate one could earn from a US dollar investment is now going to be higher than the interest one could earn from a Euro denominated investment, the demand for the USD would increase. This would lead to a higher USD value and lower EUR. Things get a bit tricky however when you consider that the increase in the interest rate has been anticipated for months now and the USD has already appreciated quite a bit now. So one could argue, is the increase in the interest rate already priced into the USD?  

Who Loses When Interest Rates Go Up?

1. Oil

Since the price of Oil is quoted in USD and the USD has gone up in value versus other currencies it has just become more expensive to buy oil. The oil industry itself is already suffering from a situation of over-supply, so an increase in the price of oil just because the USD got more expensive could be lead to lower demand which would in turn hurt the oil companies.

2. Gold

Gold also stands to lose value with an increased USD value, like many other precious metals gold is quoted in USD. Just like with oil, the cost to buy gold would have just gone up simply because the USD went up. This could in turn lead to a fall in the price of gold to counter the increased cost of acquiring it. What makes it even worse is that gold does not earn any interest and in fact it cost money the longer you hold gold since insurance costs and storage costs have to be considered.

3. Home Buyers

With increased interest rates new home buyers will face higher home loan rates and thus will be able to borrow less or will have to pay more for the same level of borrowing. Even existing home owners who have variable rate home loans will have to start paying more in interest, thus increasing their monthly loan payment and thus decreasing their disposable income.

4. Issuers of USD debt that operate outside the US

Many countries and companies which do not use the USD as their base currency also issue many bonds denominated in USD. With an interest rate increase this means that if they want to borrow new funds in USD they would also have to offer higher rates since the base rate on which all other rates are built has gone up. Furthermore, their outstanding debt has just become more expensive to service. Although the majority of bonds are issued with a fixed interest rate, since the USD would have appreciate against the currency the issuer uses as its base currency it would cost them more to pay the same amount of USD in the form of interest payments and eventually capital repayment.

How are You affected as a person living in Malta/Europe?

One may argue that the above is all well and good, but it does not affect him/her since we are situated in Malta and our interest rates are determined by the European Central Bank (ECB) and not the Fed. Although this last point is true that our interest rates are determined by the ECB which does not plan to raise interest rates anytime soon, this does not mean that we are immune to what is happening abroad.

The biggest effect that Malta will have from the increase in the Fed rate is the effect on the currency, specifically the USD/EUR exchange rate. So if the USD has gone up and is expected to go up even further this will have an effect on individuals as well as businesses. Let us take a look at some specific areas where we will be affected:

• Traveling abroad

The cost to travel to the USA will now be higher. So even though you might still have to pay $1,000 for a few days of accommodation in a New York hotel that $1,000 which used to cost you around €715 in 2011 will now cost you around €915. That is close to a 30% increase in the cost. When you consider the total cost of a holiday in the USA this difference would add up to quite a bit of change. This will be true not just for travelling to the USA of course, but to anywhere that prices in US Dollars as a main currency. So for example going on a cruise that accepts only US Dollars would become more expensive as well.

• Fuel Costs

As previously discussed, the price of oil is denominated in USD. So any other derivative of oil such as diesel and petrol for motors, fuel for airplanes and so on will also be affected by the price of the USD. Luckily for us we are in a situation where oil prices are very low due to oversupply. Hence, the increase that one would expect in the oil price is being counterweighed by the supply side keeping the price down. But if the supply had to be reduced or the demand would somehow increase the price of oil would in fact go up.

• Cost of Precious Metals

Like oil, the prices of precious metals is denominated in USD. So the cost to acquire these precious metals will be higher, even if the prices had to remain unchanged.

• Importing of goods in USD

Besides oil, many other items are bought in USD. Anything we import in USD will now be more expensive than it was just a few years ago. So importers will be negatively affected by the fall in the EUR which came about as a result of increased interest rates in the US. This also affects individuals who are used to buying items online for example.

• Exporting of Good to the USA

It is not all bad news however, the exporters will benefit, specifically the ones that export to the USA. Since in dollar terms EUR items will cost less, the items that are exported to the US would be considered cheaper and be more competitive versus other US made items. So for example the European car manufacturers will now be able to price their vehicles more competitively against their US counterparties. Unfortunately for Malta we do not export many goods to the US. But we do compete with the US in certain services industries. So the higher USD would mean that it would be cheaper to do business through Malta (and other Euroland countries) rather than through the USA.

The Bottom Line

At the end of the day, how we are going to be affected by the Fed rate cut will take quite a while to be seen. Although there will be an immediate effect, the total effect of the move will take months to come to fruition. It all boils down to expectation and real economic indicators in the end, although the Fed said that it will continue to increase interest rates it also said that this will be gradual and it did not commit to any hard target. Jobless rates in the US are still not at desired levels so if we should have weak economic indicators in 2016 the pace of the internet rate hikes will be very slow or stopped completely. What is certain is that whatever happens in the USA will definitely affect us in Euro-land, and not just on the investments side.

KD