Interest rates 101: What they mean for your investments

Interest rate decisions have become a public spectacle. They might be seen as the modern equivalent of gladiator fights in ancient Rome, where a flick of the thumb could sway the crowd into either cheers or outrage. Today, central bank governors are the financial world’s equivalent of emperors. Their decisions spark front-page headlines and fuel debate at dinner tables and across social media.

Why? Because in a country where most households carry a mortgage, every rate move hits home. It reshapes monthly budgets, changes spending habits and forces people to rethink their investment choices. But interest rates influence more than just home loans. They drive market cycles, shape asset prices and ripple through the entire financial system. 

If you're investing, it's important to understand how interest rates work. In this piece, we break them down clearly and explain why they matter.

What are interest rates? 

Interest is the cost of borrowing money. When you take out a loan, like a mortgage or use a credit card, the bank charges you interest. This is a fee for lending you the money and is usually shown as a percentage of the amount borrowed each year. You can also earn interest when you deposit money into a savings account. In that case, the bank is paying you for letting it use your money to lend to others.

Most interest rates across the economy are influenced by a key rate set by the central bank. In Australia, this is called the cash rate and is set by the Reserve Bank of Australia. In the United States, the Federal Reserve sets a similar rate known as the Federal Funds Rate. Banks use this base rate as a starting point when setting their own rates. They borrow money at or near the base rate and then charge customers a higher rate to make a profit. So when the central bank changes its rate, the cost of borrowing and the return on savings usually change as well. These shifts can affect everything from home loans and business credit to the value of the dollar and the performance of the sharemarket.

Although the RBA sets Australia’s cash rate based on local factors like inflation and employment, overseas rate changes can still have an impact. When major central banks like the Federal Reserve lift or cut rates, global markets react. Interest rates matter whether you are saving, borrowing or investing. They help shape your financial decisions, and small changes can have big effects over time. In this article, we’ll dive deep into how interest rates move markets and what those movements mean for you. But first, why change interest rates at all?

Why central banks change rates

Interest rates are one of the key levers central banks pull to steer the economy. By adjusting this lever, they influence major forces like growth, employment, and inflation. These decisions shift depending on economic conditions. When the bank cuts (lowers) interest rates, it is said to be “loosening” monetary policy or taking a “dovish” stance. When it hikes (raises) interest rates, it is “tightening” policy or acting “hawkish”.

Lower rates make borrowing cheaper, encouraging households to spend and businesses to invest. Generally speaking, this boosts economic activity. But when inflation is rising too quickly, central banks lift rates to cool demand by making borrowing more expensive. In short, they use interest rates to maintain balance. They stimulate the economy when it slows, and ease off the throttle when it runs too hot. At least, that's the hope in theory.

Let’s walk through an example. Say the economy is growing quickly. Strong demand for goods and services gives businesses the power to raise prices. But if growth becomes too rapid, inflation can spiral. That kind of instability makes it harder for households and businesses to save, invest, or plan ahead. Eventually, it can lead to a painful bust. To avoid that, a central bank might raise interest rates to cool things down. Higher rates make borrowing more expensive, which tends to reduce spending and slow demand. With less pressure on prices, inflation should start to come back under control.

The RBA’s mandate is to ensure currency stability, maintain full employment and support economic prosperity. In practice, it targets inflation of 2–3% over the medium term. The US Federal Reserve has a similar role, though framed as a “dual mandate”: to keep inflation stable and support maximum employment. Its long-run inflation target is 2%. Both central banks responded aggressively to surging inflation between 2022 and 2024. The RBA lifted rates from record lows to the highest in more than a decade, while the Fed pushed its rate from near zero to a 20-year peak. These moves flowed through to households, with consumers in both countries facing steep increases in mortgage repayments, car loans and credit card costs.

In the US, the central bank meets eight times a year to decide whether to raise, cut, or hold interest rates. In Australia, the Reserve Bank of Australia (RBA) meets 11 times a year. That means once a month, except in January. It sets the official cash rate, which directly affects mortgage repayments, savings account rates, and business borrowing costs. These decisions are often contentious. There is rarely a clear-cut answer, but when rates move, markets usually follow.

^{Source: TradingView. Chart shows the upper bound of the Fed’s policy‑rate range.}

How rates affect markets

Interest rates and stock prices do not always move in predictable ways, but generally speaking, they tend to move in opposite directions. Stocks often rise when interest rates fall, and they can struggle when rates go up. Here is how that works in theory. When interest rates are low, it costs less for businesses to borrow money. That helps them invest, grow, and potentially make more profit, which supports higher share prices. At the same time, safer options like savings accounts or government bonds do not offer much return. So investors tend to move their money into the sharemarket in search of a higher rate of return, which in turn can drive stock prices higher.

In low-rate environments, both companies and investors find it easier to take on risk. That often pushes stock prices higher, even for businesses that are not yet profitable. Sometimes that sparks speculation, where money pours into assets just because people think prices will keep climbing, not because the businesses are fundamentally strong. We saw this in action after interest rates were cut sharply in 2020. Investments like Bitcoin (BTC/USD), the ARK Innovation ETF (ARKK:US), and Tesla (TSLA:US) were among the assets that rose during this period, partly supported by low rates and government stimulus. But when rates started rising in 2022, the trend turned.

Higher interest rates increase the cost of borrowing, which can reduce business profits. They also give investors more reason to leave money in safer places, as the returns on savings and bonds improve. On top of that, rising rates can lower the value of future company earnings, which tends to drag share prices down. This is especially true for fast-growing companies that rely on future profits to justify today’s prices. So as rates climbed, many of the same assets that soared in 2020 and 2021 saw sharp falls.

When money is cheap, investors are generally more willing to take on risk. When borrowing costs rise, that appetite for risk can diminish, although the extent often depends on broader factors such as global conditions, fiscal policy, and market sentiment.

And cash? When the base rate moves, the interest rates banks pay out to ordinary savers will often change too. That means an interest rate hike makes saving more attractive and a cut does the opposite. But don’t expect a perfect correlation between the base rate and your bank account, as banks might end up pocketing some of the extra interest rather than passing it on to you.

Case study: rate debate

Is it always clear which way to move rates? Not at all! Rate decisions can be extremely controversial – economic experts just love to argue the merits of hiking versus cutting. It can be tricky to get your head around these discussions theoretically, so we’ll look at a case study: the US Federal Reserve’s interest rate decision in June 2019 and the debates around it. For background: interest rates were sitting at 2.25-2.5% after four rate hikes in 2018 (the Fed sets a target range rather than an absolute number to make it easier for it to control rates).

What was the argument for raising rates? US inflation, though not quite at the Fed’s target of 2%, was close enough to raise some hackles. With stock markets near record highs and unemployment extremely low, some investors were concerned about an overheating economy – which raising rates would help to cool. If a US recession was to hit in the near future – and most forecasts at the time agreed one was due – having the ability to slash high interest rates would be very handy. A dramatic cut in interest rates helped stimulate a flailing economy in 2008, for instance. If rates are already low when a recession hits, there won’t be much room to slice them and boost growth…

Why did people disagree? Some people think recessions can be fought without big interest rate cuts – they argue that other tools like government spending can do the job. And, with inflation below the magic number, they argued that a rate hike wasn’t yet necessary. In fact, many – including the US president – advocated a June rate cut. They pointed to indicators of an economic slowdown and fears that the US-China trade war could hurt growth even more. And they argued that the boost to investment that a rate cut could deliver would help to prolong economic expansion and stave off a recession.

What ended up happening? The Fed, ever the diplomat, decided to keep rates the same. It suggested that a rate cut was on the cards for later in 2019 – although the committee was divided and minds weren’t yet made up.

When rate cuts backfire

It’s worth noting that some economists question how heavily central banks rely on interest rate adjustments to manage the economy. Critics argue that keeping rates too low for too long can distort market signals, encourage excessive risk-taking, and lead to misallocated capital. This can contribute to asset bubbles and more painful downturns when those bubbles eventually burst.

As previously mentioned, the emergency rate cuts and large-scale monetary stimulus in 2020 are a case in point. While these measures supported markets during a period of extreme uncertainty, they also fuelled a surge in speculative investment, particularly in tech and high-growth sectors. Many of those assets later experienced sharp corrections, prompting debate about the long-term trade-offs of aggressive monetary policy.

A final consideration for investors is that not all rate cuts are market-friendly. In some situations, they can do more harm than good. During stagflation, when inflation is high and growth is weak, cutting rates can push prices even higher without lifting demand. This creates a vicious cycle where inflation accelerates, policy loses credibility, and confidence erodes. In the 1970s, attempts to stimulate growth through rate cuts only worsened inflation and delayed recovery. In such environments, investor attention often shifts toward inflation-resilient sectors, companies with pricing power, and real assets that tend to perform better when central banks have limited room to move.

^{Image: 1970s demonstration in New York City against high food prices. Protesters carry signs and banners.}

Your next steps

If you’ve made it this far, hopefully you’re convinced of just how important interest rates are to your investments. But understanding interest rates is one thing. Translating that knowledge into useful insights and practical steps for your portfolio is another.

So where do you start? Here are a few things to consider:

• Track the interest rate cycle. Understand where we are in the cycle. Are rates rising, falling, or on hold? This affects everything from borrowing costs to equity valuations.

• Follow central bank commentary. Pay attention to what both the RBA and the US Federal Reserve are saying. It is not just the rate decisions that matter, but also the tone and messaging in speeches, meeting minutes, and press conferences. Reserve Bank speeches can often provide forward guidance or subtle clues about where interest rates might be heading.

• Use tools like the CME FedWatch Tool. It shows market-based projections for the future path of US interest rates. Since the US economy has an outsized impact on global conditions, this can offer useful insight into broader monetary policy trends worldwide.

• Watch both domestic and global moves. In addition to monitoring central bank decisions, it is useful to keep an eye on key economic data, particularly from major economies like the US. For example, if US inflation begins to rise, this could shape expectations for future interest rate increases by the Federal Reserve. Such shifts may influence the Australian dollar, capital flows, and sectors on the ASX, particularly banks, resources, and exporters.

• Review your portfolio regularly. Different types of investments perform better in different interest rate environments.

• Keep your strategy long-term focused. Do not overreact to every move. Understand the bigger picture, and make considered adjustments based on your goals and risk tolerance.

By staying aware of rate shifts, both at home and abroad, and understanding their potential impact, you will be in a stronger position to protect and grow your portfolio.

In this article, you’ve learned:

• Central banks set benchmark rates that influence many other interest rates across the economy.

• Central banks often raise rates to curb inflation – and cut them to stimulate economic growth.

• Lower rates may support share prices, though the impact varies across sectors and broader economic conditions.

• People don’t always agree about which direction to move rates: there’s often a debate over the right course of action.

Disclaimer: This article provides general information only. It has been prepared without taking account of your objectives, financial situation or needs. It is not to be construed as a solicitation or an offer to buy or sell any financial instruments, or as a recommendation and/or investment advice. It does not intend to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any financial instruments. You should consider your objectives, financial situation and needs before acting on the information in this article. CMC Markets believes that the information in this article is correct, and any opinions and conclusions are reasonably held or made on information available at the time of its compilation, but no representation or warranty is made as to the accuracy, reliability or completeness of any statements made in this article. CMC Markets is under no obligation to, and does not, update or keep current the information contained in this article. Neither CMC Markets nor any of its affiliates or subsidiaries accepts liability for loss or damage arising out of the use of all or any part of this article. Any opinions or conclusions set forth in this article are subject to change without notice and may differ or be contrary to the opinions or conclusions expressed by any other members of CMC Markets.