Many investors wonder about the impact of interest rate decisions by central banks on the FTSE 100 index and share prices. Today, I’d like to discuss the potential effect of interest rate decisions by the Bank of England (BoE) and the US Federal Reserve, or the Fed, on our shares.
BoE expects low rates to stay
The BoE sets the base interest rate, which is currently 0.75%. Policymakers have recently noted that they expect interest rates to stay at low levels for many years to come.
Interest rate decisions by the BoE affect the cost of mortgages, credit cards and other borrowings, both by individuals and businesses. Typically, lower interest rates are considered good news for stock markets. In other words, there is an inverse relationship.
Rate cuts aim to add stimulus to our economy. They usually trigger mortgage, car and personal loan rates to fall, making it cheaper for consumers to borrow money.
British businesses may also find it easier to fund new investments. Many companies like utilities, such as National Grid and SSE, and telecoms firms, such as Vodafone or BT Group, tend to carry high levels of debt on their balance sheets. Therefore lower rates may mean a boost to their bottom lines.
Why the Fed matters for FTSE shares
UK analysts also pay attention to the actions taken by the Fed, which is possibly the most powerful central bank in the world,
Institutional investors would “never fight the Fed”, because when Fed Chair Jerome Powell announces interest rate decisions, money managers allocate assets accordingly.
Recent rate cuts by the Fed have been the talk of the global investing world. In July, Mr Powell hinted at the first interest rate cut in over a decade as a weakening global economy and trade wars strengthened the case for a rate cut. And on 30 October, the Fed cut US rates for the third time in four months.
When the Fed decreases rates, the US dollar usually depreciates against other major currencies, including the pound.
The pound and the FTSE 100
So what does this mean for UK investors? Most FTSE 100 companies are multinational conglomerates and up to three-quarters of their revenue comes from overseas.
When the Fed cuts interest rates and a devaluation of the dollar against the pound occurs, this may impact UK businesses that generate income in dollars. The dollars they’re earning outside the UK become worth fewer pounds, leading to a decrease in profitability. For US consumers and businesses, British goods would also become more expensive, potentially hurting UK exports overall.
However, when the BoE cuts rates, now the pound could be devalued against other major currencies, including the dollar, and the effect would be reversed.
FTSE 100 shares with the highest non-UK revenue come from various industries, including miners, industrials, oil companies and pharmaceuticals. These companies include Fresnillo, Rio Tinto, BHP Billiton, BP, AstraZeneca, GlaxoSmithKline, and Smith & Nephew.
Although many established companies will normally hedge against currency risk, earnings in the short-run may still be affected by exchange rate headwinds.
However, any potential adverse effect may easily be offset by increased business opportunities offered by a lower interest rate environment in a given economy.
My strategy in both scenarios? Carry on investing in strong companies I believe in, and watch out for short-term price dips to buy more.
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tezcang has BP covered calls (November 8 expiry) on BP ADR shares and GSK covered calls (November 8 expiry) on GSK ADR shares listed on NYSE. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended AstraZeneca and Fresnillo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.