If you want to be financially successful you have to have a basic understanding of different relationships that exist within the economic world and how different variables are correlated to somewhat predictable changes. From a high level, once you have this understanding you can speculate on which direction you anticipate certain variables to move, and act accordingly to bet on your prediction.
For example, let’s talk about interest rates. What are the consequences of rising interest rates? For starters, you can earn more interest on your savings in the bank. You’ll also have an increased interest expense if you choose to finance a home, making monthly payments rise. Now that house you could have been approved for when rates were lower, you can no longer afford, even if the list price remains constant because the additional interest now demands a higher monthly payment just outside of what you can afford.
As price of financing goes up, demand for financing, and purchasing a home, car, or anything else will typically decrease. So interest rates will directly impact purchases financed by credit, especially within the housing market where most people can’t afford to purchase a home with cash.
These are a few things that rising interest rates can have an impact on directly in your personal life. On a grander scale, when interest rates are increased by central banks in one currency, demand for that currency rises because that’s a signal of strength and if my euros are only earning me 1% in a European bank, while I could be earning 2% in a US bank then there’s an incentive for me to hold my funds in dollars in a US bank to maximize my return.
So rising interest rates are good for a country then right? Not exactly. What if you’re an exporter (sell goods to businesses or individuals in a different country) in the US and are in a rising interest rate environment here at home? If your customers in Japan have to convert their yen to dollars, and interest rates in Japan haven’t risen as well, then the yen will be devalued relative to the US dollar and a standard order that used to cost them $200,000 yen may now cost them $220,000 yen since they convert to fewer dollars when US interest rates are on the rise.
This may result in smaller orders, or loss of business to a competitor located in a country that can manufacture the same product for cheaper due to a weaker currency/stronger exchange for the yen.
Rising interest rates are also generally bad for bond investors because the value of your bond paying 2% will decline when bonds are currently being issued at 3%, all else constant. You’ll have to sell it at a discount in order to compete with the newly issued bonds with a higher rate of return.
And any of these examples would have an inverse relationship if you were to change the example to a decrease in interest rates. The point is, by understanding these relationships and knowing the multiple layers of effect that come from changing certain variables, you’ll have the knowledge to anticipate market changes and invest accordingly.
Of course that doesn’t mean you’ll always anticipate accurately, however your decisions will be made on a logical economic understanding as opposed to blind guess work. Lastly, for our rising interest rate example, as touched upon above with the euro vs dollar example, rising interest rates increase the demand for a currency because that particular currency is providing a higher risk free rate than others, which creates an incentive to hold your savings in that currency.
If I convert my 10 euros to dollars, and interest rates in the US go up, while rates in the EU remain constant, the value of my dollars relative to euros goes up and I can convert those dollars back to euros at a later date and they’d be worth more than just 10 euros due to the increased strength of the US dollar. That same principle applies to investing in commodities like gold, silver, oil, etc.
It’s all driven by supply and demand, perceived risk and reward. To get in the game you have to understand these relationships and determine how the events taking place in the world right now will impact the variables that drive macroeconomic fluctuation.
When someone lacking this understanding hears on the news that interest rates are rising, their comprehension of that statement is simply that interest rates are rising. For someone who fully understands what was discussed above, their internal response and thought process will vary drastically. They’ll think, it’s time to liquidate those treasury bonds, or a stronger dollar means cheaper imports (opposite of the exports being more expensive from the perspective of a foreign buyer above) that means I can buy more inventory for less when the change happens.
If interest rates are going to begin to rise, maybe I should get locked into a 30 year mortgage now while they’re at historical lows. The examples are countless but you get the idea. By understanding the cause and effect that the relationship between certain variables have on each other you can make investment, and personal financial decisions that work in your favor.
A lack of economic understanding allows the rich to get richer and the politicians to exploit the ignorance of the masses who don’t fully understand the consequences of certain policies that are proposed.
As discussed, one change can impact a variety of different variables in opposite directions. If I want to sell an ignorant person on an idea to support my cause, I emphasize the positive impacts it will have on them and disregard all other variables. This way those people are on board, while I get what I want, for an ulterior motive that serves a mega corporation that sponsored my political campaign, so that I would use my power to support their best interests.by