Why interest rates matter for ASX 200 shares

ASX 200 shares boomed in late 2020 but are rising long-term interest rates something to worry about for Aussie share investors?

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A piggy bank attached a bicycle pump floats up, indicating rising inflation

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There’s been increasing talk in recent days about rising bond yields and how that may impact ASX 200 shares. Many investors may be thinking, “what do interest rates have to do with my shares?”

There could be some important relationships and potential implications from the current interest rate spike.

What’s going on with interest rates?

In simple economic terms, central banks like the Reserve Bank of Australia (RBA) lower interest rates to kickstart the economy.

When rates are low, individuals and corporations are more likely to borrow money. That money is then invested back into assets and projects that boost employment and help drive economic growth.

One common misconception is that central banks like the RBA set interest rates. The RBA meets each month to discuss monetary policy and does set a target official cash rate (OCR).

Actual interest rates are set by the market, and while influenced by monetary policy, are subject to market forces.

What’s been happening is interest rates on long-term bonds are starting to spike higher. Bond yields increase when prices decrease, which happens when there is lots of selling. Here is where it starts to matter for investors in ASX 200 shares.

That increase in yields (or increase in selling) could be for a variety of reasons, one of which may be investors expecting higher inflation.

Increased money supply and an early-stage economic recovery could see an increase in inflation, which is bad for long-duration investments like 10-year Treasuries.

Why do interest rates matter for ASX shares?

The vast majority of investors diversify their portfolio across asset classes based on expected risk and return metrics, as well as intra-portfolio correlations.

If bond yields are spiking, buyers of those bonds should receive a higher premium for holding that investment. If that’s due to expected higher inflation, there are a number of ASX 200 shares that could be impacted.

One area that has been hammered recently in global markets is technology. ASX 200 tech shares like Afterpay Ltd (ASX: APT) and Xero Limited (ASX: XRO) boomed in 2020 as investors looked for long-term growth potential amid the uncertainty.

However, the “bird in the hand” adage means that a dollar today should be worth more than a dollar tomorrow. That’s especially the case if there’s high inflation, which would erode the present value of those future earnings.

That could be a key driver in higher share price volatility for ASX 200 shares like Afterpay in recent weeks.

Foolish takeaway

No one really knows why interest rates are spiking around the world but there are some fundamental economic principles that can help to provide context to the recent market movements.

If interest rates are moving up in the expectation of inflation increases, that could have knock-on effects for a number of ASX 200 shares including those in the tech sector.

If it’s due to expected economic growth and subsequent interest rate rises, then it could be a very different story.

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Motley Fool contributor Ken Hall has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of AFTERPAY T FPO and Xero. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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