How will higher interest rates affect the global financial markets?

Ever since the pandemic started disrupting the flow of goods, services and the wider economy, much of the relief from national governments and policymakers came in the form of quantitative easing and lower interest rates. However, now that inflation is reaching critical mass, rising by 7% year over year – the highest level in four decades - all eyes are on the Fed and the inevitable interest rate hikes and tapering of bond-buying programs. 

As such, today we are taking a look at how the financial markets are expected to react as we are entering a year with tighter monetary policy and higher interest rates. 

Currency pairs

Overall, the currency markets are one of the first to respond to any fiscal or monetary policy changes. In fact, the anticipation of interest hikes has already moved the rates of most major pairs. In addition, the expectation that multiple interest rate hikes will occur in 2022 has heightened interest in the dollar. 

In general, higher interest rates lead to a rise in the value of the currency as it becomes more attractive to foreign investors who seek higher yielding currencies. 

Even with Omicron concerns and inflation running rampant, the dollar continues to dominate against its peers. And the recent decline in the value of Bitcoin, has been noted by some analysts as a response to the expected interest rate hikes. If this is indeed the case, then dip opportunities could prop up the cryptocurrency market as the Fed officially announces its policy. 

Stock market

The stock market enjoyed a stellar performance in 2021, and despite the upcoming policy change by the Fed, US indices are breaking record highs. Looking at the big picture, higher interest rates are a bearish theme for stock prices. Higher interest rates translate to higher borrowing costs, which means there will be less capital to invest in the growth of the company. 

Similarly, higher interest rates also affect working people, especially those who are in debt or mortgaged as they have to spend more capital on their loans. Capital that would otherwise end up in the stock market. So, higher interest may have a profound effect on the stock market across the board. 

However, with the pandemic still taking its toll on the global economic recovery, curbing inflation is crucial. As long as interest rate hikes don’t surprise investors, the market, as per the experts, is expected to be rather stable and continue its upward trend. Still, there is no determined framework to predict the response of the markets - in these unprecedented times, and we can expect heightened volatility amid the new status quo. 

Commodities

Commodities are another asset class that’s highly sensitive to the performance of the dollar. The gold market, like other precious metals, is determined by the forces of supply and demand. Interest rates do not have any direct impact on the gold market, but since gold is negatively correlated with the US dollar – it is safe to assume that there might be some adjustments in this market as well. 

Also, according to previous historical corrections, higher interest rates have proven to be bearish for the gold market. This is validated by the data of the first week of the year. In fact, the price of gold has already moved on the correction path due to the news of the impending hikes. 

There is still some upside momentum with investors buying the dip, but the long-term forecasts are in favor of the bears. As the US dollar is likely to benefit from the interest rate hikes, we can also expect further shocks to the crude oil market. Since oil barrels are bought and sold in US dollars, when the price of the dollar rises, the price of oil for other countries rises as well. This is a major shift in the supply and demand dynamic. Many developing countries - low on funds but major consumers of oil - tighten their grip on their oil budgets. Eventually, this may lead to a slump in oil prices. 

In a nutshell

The announcement of interest hikes has already started affecting the global financial markets, and while the US dollar may benefit with higher exchange rates in its favor, other assets should start slowing down. The stock market has been witnessing some healthy volatility bouts, and the commodities have responded with a dip. Ostensibly, further volatility should be expected for the stock market as indices start to shrink. A similar reaction is expected for most major currency pairs aside from the US dollar. 

All these are in conjunction with the historical behavior of these assets. However, with the pandemic in the backdrop, investors should be prepared for different outcomes as well.