Rates of interest and the forecasting of their future values are one of the most important criteria which need due consideration when taking an investment decision. When the term interest rates comes to mind, one might easily relate interest rates on fixed income or bond investments and how this asset class can be impacted in the event of an increase in rates of interest.

However, interest rates affect all asset classes within the investment spectrum of global capital markets, from currencies to equities, to financial derivative investments and bonds. Having a good understanding of how interest rates are determined, move and forecasted is key in taking well-informed asset allocation and investment decisions.

Say an investor wishes to place money in a term deposit at a bank; an investor’s decision should be based on their outlook for interest rates. If interest rates are expected to fall, an investor might wish to lock in the rate of interest now, whereas if interest rates are expected to rise an investor might wish to postpone committing any monies to longer term investments due to the notion of opportunity cost.

From simple decisions of placing money in fixed-rate term deposits to an equity investment, interest rates should be at the forefront of investors', asset managers' and financial advisors' minds when being faced with the daunting task of putting money to work in the financial system.

It is no secret that forecasting interest rates is one of the most complex parts and elements of applied macroeconomics. However, over the years, scholars have come up with detailed studies on the matter and have boiled down the forecasting of interest rate to 3 key inputs:

• The level of money supply from savers (primarily households)

• The demand of money from corporations to plough such monies back into the economy in the form of investment in plant, equipment and machinery

• The government’s level of supply or demand of domestic currency as per Central Bank intervention, through the implementation of fiscal and monetary policies, such as increase in taxes, Quantitative Easing, etc.

In addition, one needs to appreciate the difference between real and nominal rates of interest.

Say for example an investor places €100,000 in a 1-year term deposit at a rate of 3 per cent, with an expected nominal rate of return of €3,000. However, what an investor wants to know is what the value of that €3,000 is expected to be in a year's time.

The consumer price index, one of the key measures of inflation, measures purchasing power by averaging prices of goods and services of families. If inflationary expectations one year from now is 1 per cent, the value of €1 depreciates by 1 per cent a year in terms of the goods and services it can buy, and therefore part of the €3,000 earned is eroded by the reduction in purchasing power brought about by inflationary pressures. And in this example, the real interest rate would equate to 2, adjusted for inflation. It is therefore of pivotal importance to distinguish between nominal interest rates – the rate of growth of money – and real interest rates – the growth rate in purchasing power.

In investment decisions, asset managers base their asset allocation choices based on their expectations of interest rates as well as projections of inflationary levels. Although there are an array of different types of interest rates which tend to move in tandem, economists generally refer to interest as if there was one single rate which encapsulates all rates.

While the fundamental factors which determine real interest rates are the propensity of households to save ad expected investment by companies (the demand and supply of money), recent central bank intervention have given us reason to place a greater weighting on central bank intervention (in the form of ultra-accommodative stances) as one of the most important inputs in the interest rate formulae, particularly at a time when interest rates are close to historically low levels.

This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.