Here is a quick breakdown of the relationship between interest rates and stocks
The stock market reacted well to this news and continued its rally.
Why are investors so happy? What is the relationship between interest rates and stocks?
What is an Interest Rate?
An interest rate refers to two things:
- The cost of credit: the interest rate is the amount a lender charges a borrower.
For example, a $100 loan with a 1% interest rates means you’ll have to pay back $101. A 25% interest rate means you’ll have to pay back $125.
In essence, a high interest rates means that credit is expensive. A low interest rate means that credit is cheap.
Interest rates are important because they impact the cost of mortgages, consumption in general and a business’ capacity to borrow money.
2. The returns on savings: the amount generated from savings.
For example, a savings account with a 1% interest rate will generate a $1 return on a $100 deposit.
Similarly, a $100 investment in a government bond with a 5% coupon will generate $5 of interest every year.
Who Sets the Interest Rate?
In most countries, the central bank sets the interest rate.
In the USA, the Federal Reserve (Fed) is in charge of setting the nation’s interest rates.
The Fed sets two main rates:
- Federal Funds Rate: The rate at which banks lend each other money during the night.
- Discount Rate: The rate at which banks borrow money from the Fed.
In general, the Discount Rate is higher than the Funds Rate in order to encourage banks to transact with each other rather than with the Fed.
Why are these interest rates important?
These rates have a profound effect on the economy in general and the stock market in particular.
When interest rates change, it takes about a year for the effects to be felt.
However, the effect on the stock market is often immediate.
Understanding the relationship between interest rates and the stock market is vital for investors. It will help you fathom the impact of fluctuating rates on stocks. In addition, it will help you make better investment decisions.
Why Does the Fed Change Its Rates?
The Fed changes its rates to control inflation.
Inflation is the continued rise in the prices of goods and services. As you may know, inflation causes your money to lose value over time. In fact, the US dollar has lost more than 90% of its value since 1913.
The Fed analyzes several economic indicators, such as the Consumer Price Index and the Producer Price Index, to measure the economy’s well-being. If these indicators rise above 2-3% per year, the Fed will increase interest rates to control inflation.
How do interest rates control inflation?
As a general rule of thumb, high interest rates control inflation whereas low interest rates cause inflation.
When the Fed increases rates, credit becomes more expensive. This means that less people and businesses can afford to borrow money. Thus, the total money supply decreases and inflation is kept low.
On the contrary, when the Fed lowers interest rates, credit becomes cheaper. This means that more people and businesses can afford to borrow money. Thus, there is a rise in consumption and investment, which produces inflation.
Here is a graph showing the fluctuation of the Fed’s Funds Rate over the past 20 years. As you can see, they have a tendency to rise and fall sharply. Also, they sometimes remain close to zero for long periods of time.
What Happens When Rates Increase?
When the Fed increases its rates, the cost of credit immediately increases.
This has a direct impact on consumers and businesses.
Since the rates at which the banks borrow from the Fed increase, the rates the bank charge their clients also increase.
Thus, the cost of credit increases and the quantity of money economic agents can borrow goes down.
When consumption decreases, corporate revenues and profits also decrease. This has a negative effect on corporate earnings and share prices tend to fall.
What Happens When Rates Rise Too Quickly?
Interest rate increases must be gradual and well timed.
If interest rates increase too quickly, economic agents don’t have time to adapt. Thus, the economy must be doing well enough to absorb an increase in the cost of credit. If not, economic activity will grind to a halt and a recession may occur.
What Happens When Interest Rates Fall?
When the economy is in crisis, the Fed can lower interest rates to stimulate it.
Lowering interest rates produces the reverse effect than increasing them. Credit becomes cheaper so individuals and businesses can afford to borrow money. Thus, household consumption increases, corporate profits increase and their investment capacity rises. In turn, stock prices go up.
When rates are low, two types of companies benefit the most:
- Dividend paying companies, such as energy companies, utilities and REITs
- Corporations with stable cash flows and low debt are able to borrow cheap money.
What happens when rates stay low for a long time?
Low interest rates stimulate economic activity, bolster consumption and encourage corporations to invest.
However, maintaining low interest rates for too long can cause inflation.
Thus, the central bank needs to monitor economic activity to ensure rates remain at an optimal level.
The Relationship Between Interest Rates and Stocks
If investors believe that a corporation’s growth rate will slow down or its profits will decrease, either due to higher debt burden or lower revenues, its anticipated future cash flows will decrease. If every other factor remains the same, the stock price will decrease.
In a scenario where hundreds of companies suffer falling share prices, the entire market may plunge.
With lower growth and depressed cash flows, holding stock will be viewed as less desirable than other investments.
Furthermore, if interest rates are high, stock market investing may appear too risky compared to safer alternatives. For example, bonds, high interest savings accounts and term deposits will be viewed as more attractive than stocks.
Why would you risk your money in stocks if you are guaranteed inflation-beating returns?
The Impact of Expectations
Sometimes, the market reacts to interest rate fluctuations even when there is no direct impact on corporations.
Keep in mind that this is first and foremost a psychological factor.
If the fed’s actions differ from expectations, the aforementioned economic theories don’t apply.
Let’s imagine that investors believe the Fed will lower rates by half a basis point. The euphoria drives a week-long stock market rally prior to the announcement. However, against all odds, the Fed finally reveals a quarter basis point drop in interest rates. While the rate drop may be good for the stock market and the economy, the stock market may actually fall because investors got carried away.
Another thing to keep in mind is that the current economic situation can also affect the market’s reaction. If the economy is doing well, an increase in interest rates may not hinder the stock market’s rally. Conversely, if the economy is not doing well, a sharp drop in interest rates may not suffice to compensate for the decline in economic activity – it may even be perceived as a sign that things are about to get worse.
Interest Rates and Stocks: Key Takeaways
The relationship between stocks and interest rates is complicated.
However, as a general rule:
- Lower rates fuel stock market rallies
- Higher rates cause stock market slowdowns.
That said, keep it mind that it’s almost impossible to accurately predict how the stock market will react to interest rate changes in the short term.