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Case study · Invest on your own
A rate rise and Mei's investments
A case study for the economics side of "Invest on your own": a central bank raises interest rates to fight inflation, and the effect on one investor's savings, bond fund and global share fund.
General education, not financial advice.
Mei, 40, invests for the long term and keeps an emergency fund. The people and figures are made up, but the mechanics are real. This is a worked example, not advice for your situation.
The news. Inflation is running at 5%, above the central bank's 2% target. The central bank raises its main interest rate from 4% to 5%, and yields on medium-term government bonds rise by about one percentage point. Over the following weeks the home currency strengthens about 5% against the US dollar.
What Mei holds
| Holding | Value | Detail |
|---|---|---|
| Easy-access savings | 5,000 | Variable rate |
| Bond fund | 10,000 | Average duration about 7 years |
| Global share fund | 20,000 | About 60% in US-dollar shares |
Duration, which most bond fund factsheets show, is a rule of thumb: when yields rise by one percentage point, the fund's price falls by roughly its duration in percent. It works best for small, fairly even moves in yields.
Your task
- Why does the central bank raise rates when inflation is high? What is the cost?
- What happens to Mei's savings rate?
- Roughly how much does the bond fund lose, and is that loss permanent?
- How does the stronger home currency affect the global share fund, before any change in share prices?
- What should Mei not do, and why?
Solution
Try the task first, then open one step at a time and compare.
Step 1: why raise rates
Higher rates make borrowing dearer and saving more rewarding, so households and firms spend and invest less. Lower demand eases the pressure on prices. The cost is slower growth and, usually, some rise in unemployment for a while: the short-run trade-off between inflation and unemployment. Economists disagree about how hard and how fast to act; that is a policy judgement, not a fact.
Step 2: the savings
A variable-rate account usually follows the central bank's rate, often partly and with a delay. If Mei's rate rises by, say, 0.5 to 1 point, 5,000 earns about 25 to 50 more a year. Still check the real rate: with inflation at 5%, even a better rate may not keep up.
Step 3: the bond fund
Yields up about 1 point, duration about 7: the price falls about 7%, roughly 700 on 10,000. The fall is real in today's prices, but the fund now buys bonds paying higher interest. Held for about its duration, the higher income tends to make up for the price fall, if yields move once and fairly evenly and the fund keeps a similar duration; it is a tendency, not a guarantee. A long-term holder is mostly affected on paper in the short run; someone who must sell next month is affected for real.
Step 4: the currency
About 60% of 20,000 is in US-dollar shares: 12,000. If the home currency strengthens 5%, those dollars buy about 5% less at home: 12,000 × (1 ÷ 1.05 − 1) ≈ −570, even if the shares themselves don't move. Currency moves can go either way; over long periods they tend to matter less than the shares' own returns, but in any one year they can be large.
Step 5: what not to do
- Don't sell the bond fund in a panic after the fall: that turns a paper loss into a real one, just as higher yields start working for her.
- Don't try to time the next move. Rate decisions are announced, but markets usually move before them, on what investors expect.
- Do check the plan still fits: her emergency fund, her mix of bonds and shares, and when she will need the money.
Check yourself
Nothing here is graded or saved.