How does the interest rate affect the stock market?

The investment community and financial media pay close attention to interest rates—the price a borrower pays to borrow money—and for good reason. When the U.S. Federal Open Market Committee (FOMC for short), or any other central bank committee, sets a target for the interest rate at which banks borrow and lend to each other, its action affects the global economy as a whole because of the U.S. dollar’s status as a reserve currency. It also affects the U.S. stock market. Understanding the relationship between interest rates and the stock market can help investors understand how central bank policy can affect their investments and, therefore, make better financial decisions.

The interest rate and its impact on stock prices

The prime interest rate drives the markets. But why is it so important and what is its function, you can read in this article here. The interest rates that commercial banks charge on the loans they provide to their customers are formed almost entirely by the prime interest rate in the economy. For followers of the Austrian School of economics, the interest rate embodies the time preferences of consumers, and for mainstream economists it is simply the price that the central bank sets in an attempt to control inflation. By increasing it, central bankers try to reduce the money supply, which in turn makes it relatively more expensive. Conversely, when they reduce the interest rate, the money supply increases, which makes borrowing money cheaper and easier, which aims to encourage consumption.

What happens when interest rates rise?

When the central bank increases the base rate, it does not directly affect the stock market itself. The only immediate effect is that it becomes more expensive for commercial banks to borrow money from the central bank. Since it costs them more, they increase the interest rates they charge their customers. The latter are in turn affected by an increase in interest rates on credit cards, mortgages, consumer loans, etc., especially if these loans are taken out at a variable rather than a fixed interest rate. This leads to a reduction in the money that consumers can spend. Businesses are affected more directly, because they also borrow money from banks to operate and expand their operations. When banks make loans more expensive, companies do not take on as much debt as they would pay higher interest rates. Higher costs can slow down a company's growth expectations; it may limit its expansion plans. However, even at relatively high interest rates, the prerequisites for the creation of zombie companies and sectors that are created and expanded at lower interest rates would not be present.

Interest rates and the stock market

If a company is perceived to be experiencing a decline in growth or is less profitable – either through higher debt costs or lower revenues – expectations for the value of future cash flows (calculated using the Discounted Cash Flow method) will fall. All other things being equal, this will lower the company's stock price.

If enough companies experience a decline in their stock prices, the entire market or a key index (e.g., Dow Jones Industrial Average, S&P 500) will also decline. With lower expectations for the company's future cash flow growth, investors will receive lower returns, making owning stocks relatively less desirable. They may also be viewed as too risky compared to other investments.

Interest rates and the bond market

Interest rates also affect bond prices. There is an inverse relationship between bond prices and interest rates, meaning that when interest rates rise, bond prices fall, and vice versa. The longer the maturity of a bond, the more it will fluctuate in relation to interest rates.

When the central bank is in the process of raising the key interest rate, government securities are often seen as a very desirable investment. This is because the so-called risk-free rate of return increases, and with it the overall required return for investors to invest in stocks increases. You can read more about the risk-free rate of return here. Therefore, if the desired risk premium decreases (the additional return that an investor requires when investing in a stock compared to a bond, caused by the increased risk), while the potential return remains the same or lower, investors will find that stocks have become too risky and will invest their money elsewhere.

One way governments and businesses raise money is by selling bonds. As interest rates rise, the cost of borrowing becomes more expensive. This means that the demand for bonds with lower yields will fall, which will cause their price to fall. As interest rates fall, it becomes easier to borrow money, which leads many companies to issue bonds to finance new ventures. This will increase the demand for higher-yielding bonds, which will also cause bond prices to rise.

What happens when interest rates fall?

When economic growth slows, the central bank lowers interest rates to stimulate financial activity. Investors and economists also view lower interest rates as a catalyst for growth. Increased borrowing, hence increased consumption. Consumers spend more because relatively lower interest rates encourage them to finally be able to afford to spend more. Businesses will be happy to finance mergers, acquisitions, and expansions at a lower cost. This increases their future earning potential, which in turn leads to higher stock prices. Companies with strong cash flows and balance sheets that benefit from cheaper financing are the ones that benefit from lower interest rates.

Impact of interest rates on stocks

Changes in interest rates also affect investor psychology, a very important and recently emerging topic in the field. When the central bank announces an interest rate increase, both businesses and consumers will reduce their spending, which, according to the general opinion, will lead to a decline in income and stock prices. On the other hand, when interest rates fall, the psychological attitude is that consumers and businesses will increase their spending and investment, which will lead to a rise in stock prices.

The business cycle and rather the current state of the economy can also influence the market reaction. In a weakening economy, the help that central bankers try to provide through lower interest rates is not enough to compensate for the decline in economic activity, and vice versa: towards the end of an economic boom, when the central bank raises interest rates in order to cool the economy, some sectors maintain their good performance.

Conclusion

Although the relationship between interest rates and the stock market is relatively indirect, they tend to move in opposite directions: as a general rule, when the central bank lowers the base interest rate, the stock market rises, and vice versa. However, this is just an unwritten rule, and there is no guarantee how the market will react to a change in interest rates.

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