The financial media as well as the investment community remain typically concerned with interest rates, which refer to the amount charged as a percentage on a loan.
Essentially, any change in interest rates tends to have far-reaching negative and positive effects on the stock market. When the Federal Reserve (Fed) makes changes to the borrowing and lending rates, the effect of such undertaking is felt across the country’s economy.
In this respect, individual investors and other stakeholders should gain a proper understanding of the complex relationship between the stock market and interests to make strategic and change-driven investment and financial decisions.
Types of Interests Rates
The stability of markets in the United States is determined by the overnight or federal funds rate (FFR). FFR refers to the rate that the Fed charge depository institutions for the amount borrowed to control inflation.
By increasing the overnight rate, the Fed shrinks the money supply and makes it expensive to obtain, meaning that people have less disposable income to purchase or do things. In contrast, a decrease in the FFR increases money supply, making it relatively cheaper to borrow. As a result, individuals spend more.
The FFR dictates the prime interest rates (PIRs), which is the amount of money expressed as a percentage that commercial banks charge the most credit-worthy clients. When the FFR rises, the PIRs charged by a given commercial bank also rise.
At the same time, the overnight rate plays a fundamental role in determining the basis for rates charges on mortgage and annual percentage rates (APRs). For instance, the increase in FFR has a ripple effect on the economy in that people will spend less, affecting profits and revenues adversely.
Interest Rates Today and Stock Prices
Individual companies, consumers, and other players in the stock market react promptly to interest-rate changes. In their recent quantitative study to investigate the relationship between the stock price and interest rates, Alam and Uddin (2009) argue that the latter affect investors’ psychology.
For example, when the Fed hikes the FFR, consumers and businesses cut on their spending, which leads to the fall in earnings and a significant drop in stock prices. In contrast, a reduction in FFR increases investment and spending, causing the rise in stock prices.
The Bond Market
In addition to its significant role in determining stock prices, a change in interest rates affects bond prices as well as the return on T-bills, CDs, and T-bonds. The rise in interest rates lowers the prices of bond, and vice versa (Wuhan & Khurshid, 2015). Businesses and governments often sell bonds to raise money.
When the FFR moves up, borrowing becomes costly. As a result, the demand and price attached to lower-yield bonds drop. A fall in the interest rates makes it easy to borrow money, meaning that companies respond by issuing new bonds with the sole purpose of financing new ventures.
The longer the bond’s maturity is, the more it fluctuates with the rise or fall in the interest rates. In this case, income-oriented investors view a reduction in FFR as a decreased or lack of opportunity to earn from interest. They understand that newly issued annuities, treasuries, and other investments will not pay as much.
Accordingly, a decrease in FFR typically prompts an investor to invest in the equity market as opposed to the bond markets. Equity markets increase the return on investment (ROI) due to the influx of capital.
The Stock Market and Interest Rates
The discussion above has shown how the changes in the interest rates rock different markets, affecting the stock market in various ways. For example, if a company is less profitable or records slow growth through reduced revenue or increased debt expenses, the future cash flows drop.
The main effect of this occurrence revolves around the fall in the company’s stock. If different business organizations experience major reductions in their respective stock prices, the key indexes directly and indirectly associated with the whole market go down.
Stock ownership becomes less profitable and desirable for investors because the lowered expectation in a company’s future cash flow and growth undermine the benefits of stock price appreciation. Additionally, they view investing in equities as risky when compared to investments.
On the contrary, some sectors in the stock market tend to benefit a great deal from the rise in interest rates. The financial industry, including mortgage companies, banks, insurance firms, and brokerages, often earns more with higher interest rates as they charge higher PIRs for lending.
The Bottom Line
It is evident that the relationship between the stock markets and interest rates remains complex, multifaceted, and somehow indirect. Most importantly, the two are inversely proportional to one another. When the Fed reduces the FFRs, the stock market goes up. On the other hand, when the Fed raises the FFR, the stock market goes down.