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Interest rates rise again in March (as announced by the ECB)

The European Central Bank (ECB) had already announced that it would raise its key interest rates by an additional 0.50 per cent in its meeting on 16 March. And so it did, in line with its determination to ensure the timely return of inflation to the 2 per cent medium-term target. More specifically, the deposit facility rate went up from 2.5 to 3 per cent. This is the rate at which euro-area commercial banks earn money on the deposits held with their respective national central banks, which, along with the ECB, form the Eurosystem.

It is worth remembering that raising and lowering the key interest rates are the main tools of monetary policy, i.e. the 'medicine' administered by the ECB to treat excessively high levels of inflation and deflation, which are some sort of 'disease' for the economy.

The news of the ECB's decision on key interest rates has been followed closely by financial operators, as it has both direct and indirect consequences for all interest rates, that is, for the cost of money (in other words, how much it costs to borrow a sum of money). Changes in interest rates, in turn, have consequences for the prices of financial assets.

More specifically, an increase in interest rates causes a decline in the prices of fixed-rate bonds, whereas a decrease in interest rates causes their prices to rise.

Why do fixed-rate bonds lose value when rates go up?

In short, interest rate hikes cause an increase in the yields on newly-issued bonds. This means that entities issuing bonds to raise funds must now offer higher returns. Consequently, the bonds that were issued before the increase in interest rates become less appealing to investors, who will only buy them at a lower price, to compensate for the lower return.

A simple arithmetic formula can help us understand the inverse correlation between the price of a fixed-rate bond and interest rates.

Let's assume we buy a 1-year fixed-rate bond, which, on the maturity date, will repay the €100 we invested, as well as €1 worth of income in the form of interest; the bond's interest rate, or yield, is therefore 1 per cent.

The purchase price of the bond will be as follows:

Purchase price= capital at maturity divided by percentage interest rate plus 1 , that is € 101 divided by 1+1%, equal to 100 euros

If, shortly after our purchase, the interest rate grows from 1 to 3 per cent, the price of our bond will change as follows:

Price is equal to 101 divided by 1+3%, that is 98,06 euros

The rates have increased from 1 to 3 per cent and the bond price has decreased by nearly €2, from €100 to €98.06!