Inflation, interest rates, shares and bonds

According to Eurostat's flash estimate, euro-area inflation declined to 10.0 per cent in November, from 10.6 per cent in the previous month. The drop exceeds our expectations, which is good news. A few weeks ago, news of a similar inflationary trend in the United States was greeted with enthusiasm by the markets, causing a decrease in market rates and an increase in the value of bonds and shares. The reaction of Italian financial markets has not been as noticeable. Market interest rates (for instance, the 10-year BTP yield) have barely moved, whereas euro-area stock-market indices have only slightly picked up.

What has inflation (i.e. the increase in consumer prices) got to do with interest rates, financial markets and the value of our investments?

Let's start by discussing the relationship between inflation and interest rates. As we know, keeping inflation low is the primary objective of central banks. Interest rates are the main tool used by central banks such as the ECB for this purpose. Specifically, when inflation is high, the ECB raises its key interest rates, and when inflation is low, it cuts them. An increase in interest rates, such as those applied by commercial banks to their clients, tends to hinder investment and consumption, which in turn, within a few months, will result in weaker consumer demand and, consequently, in lower prices. This way, the ECB can gradually bring inflation down to its target levels.

Let's move on to the relationship between interest rates and the value of shares and bonds traded on financial markets. This is where things get complicated. If rates increase across all time horizons – from the very short-term rates that are controlled by central banks to long-term rates, ranging from 10 to 30 years – the value of fixed-rate bonds will fall. There is an automatic and inverse correlation between the price of a fixed-rate bond and interest rates.

Let's make an example that illustrates the reason behind this correlation. Just think of a 10-year BTP with a 4 per cent yield. If one day the 10-year market rate rises to 4.5 per cent, that BTP's yield will no longer be appealing. Nobody will buy it and get a 4 per cent yield when they can invest their money elsewhere and get 4.5 per cent with the same degree of risk. Therefore, for the yield of the old BTP to match the market rate, its price must decline. Technically, the price of the BTP drops because the current value of distant-future monetary flows – that is, the value of the coupons at maturity plus the principal to be repaid – decreases as interest rates increase.

The same goes for shares, generally speaking: if market yields increase, so does the return I expect to make if I invest in shares. For that to be the case, with dividends being equal, share prices must fall, because the current value of future dividends decreases. However, there are further reasons why the value of shares is correlated to interest rates, as we explain in the box below.

So, going back to the good news about euro-area and US inflation in November, the fact that inflation is decreasing more than expected globally may lead central banks to raise policy rates less than they were going to. Indeed, medium- and long-term market rates have started declining and the prices of bonds have started going up. Investors' perception of the risk of exorbitant rates negatively impacting economic growth has abated, which has helped share prices pick up.

In conclusion, we wish to take this opportunity to remind you of the golden rule for investing your savings: diversify, i.e. don't put all your eggs in one basket, and invest in several instruments with different characteristics instead. These include deposits, government securities and other short-, medium- and long-term bonds, whether fixed- or variable-rate or inflation-linked, shares from different sectors and countries, and so on. You can do it yourself, by purchasing each financial instrument on your own, or more easily through ETFs or investment funds that allow you to invest in many financial assets through one vehicle.