What happened to the interest rates?” “Where are the main destinations?” “Did the Fed announce a rate hike next month?”
Interest rates, the cost someone pays for the use of other people’s money, tends to obsess over the investment community and the financial media – and with good reason. When the Federal Open Market Committee (FOMC) sets targets for the federal funds rate at which banks borrow and borrow from one another, those stocks have a ripple effect throughout the US economy, not to mention the US stock market. And, while it usually takes at least 12 months for a rate hike or cut to be felt in an expanding economic manner, the market response to change (or news of change) is often quicker.
Understanding the relationship between interest rates and the stock market can help investors understand how changes can affect their lives, and how to make better investment decisions.
Interest Rates that Affect Shares
The interest rate that moves in the market is the federal funds rate. Also known as the overnight interest rate, this is the fee depositors have to pay to borrow money from Federal Reserve banks – the interbank borrowing rate, so to speak.
The federal funds rate is the Fed’s way of trying to control inflation (rising prices, because too much money chases too few goods: demand exceeds supply). Basically, by raising the federal funds rate, the Fed tries to reduce the money supply available to buy or do something, by making money more expensive to obtain. Conversely, when lowering the federal funds rate, the Fed increases the money supply and, by making it cheaper to borrow, encourages spending. The central banks of other countries do the same for the same reasons.
Check out some of the broker’s online sources offering to track the latest central bank policies here.
Why is this number, which bank pays the others, so important? Because the prime rate or base rate on loans – the interest rates commercial banks charge the customers with the most credit scores – is largely based on the federal funds rate. And prime rates are the basis for mortgage loan rates, credit card APRs and a number of other consumer and business loan rates.
What Happens When Interest Rates Rise?
When the Fed raises the federal funds rate, it doesn’t directly affect the stock market itself. The only immediate effect is that it becomes more expensive for banks to borrow money from the Fed. But, as noted above, increases in the federal funds rate have a ripple effect.
First ripple: Because it is more expensive to borrow money, financial institutions often increase the interest rates they pay their customers to borrow money. Individuals are affected through increases in credit card and credit interest rates, especially if these loans carry variable interest rates. This has the effect of decreasing the amount of money that consumers can spend. After all, people still have to pay bills, and when those bills become more expensive, households are left with less income. This means that people will spend less discretionary money, which will affect both the top and bottom line businesses (i.e., income and profits).
But business is also being affected in a more direct way. They also borrow money from banks to run and expand their operations. When the bank makes the loan more expensive, the company may not borrow as much and will pay higher interest on the loan. Inadequate business expenses can slow down the company’s growth; it may dampen expansion plans and new ventures and even encourage cuts. There could be a drop in earnings too – which, for public companies, usually means the stock price takes a hit.
Interest Rates and the Stock Market
So now we see how those ripples can rock the stock market. If a company is seen to be reducing its growth spending or generating less profit – either through higher costs of debt or less revenue – then the estimated future cash flows will fall. All else being equal, this will lower the company’s share price. (A key way to value a company is to take the discounted sum of all future cash flows from that company to date. To arrive at a share price, take the amount of discounted future cash flows and divide by the following number of shares available. )
If enough companies experience a decline in their share price, the entire market, or a major index (such as the Dow Jones Industrial Average or S&P 500) that many liken to the market, will fall. With the decline in expectations of growth and future cash flows of the company, investors will not get much growth from the appreciation of share prices, so share ownership is less desirable. Furthermore, investing in equity can be seen as too risky compared to other investments.
However, several sectors have benefited from the increase in interest rates. One sector that tends to benefit most of the financial industry. Banks, brokers, mortgage companies and insurance company revenues often increase because interest rates move higher, because they can charge more for loans.
Interest Rates and the Bond Market
Interest rates also affect bond prices and the rates of return on both CDs and T-bonds and T-bills. There is an inverse relationship between bond prices and interest rates, which means that as interest rates increase, bond prices fall, and as interest rates fall, bond prices increase. The longer the maturity of the bond, the more it fluctuates in relation to interest rates. (Learn the basic rules that govern how bonds are priced at
Bond Market Price Statement. When the Fed raises the federal funds rate, the newly offered government securities, such as Treasury bills and bonds, are often seen as the safest investment and will usually experience a corresponding rate hike. In other words, the “risk free” rate of return rises, making the investment it is more desirable. As the risk-free rate increases, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same or becomes lower, investors may feel the stock is becoming too risky, and will put their money elsewhere.
One of the ways that governments and businesses raise money is through the sale of bonds. As interest rates increase, borrowing costs become more expensive. This means that the demand for low-yield bonds will fall, causing their prices to fall. As interest rates fall, it becomes easier to borrow money and many companies will issue new bonds to finance new ventures. This will cause the demand for bonds with higher yields to increase, resulting in higher bond prices. Bond issuers can choose to refinance by calling up existing bonds so they can lock in lower interest rates.
For income-oriented investors, the Fed reducing the federal funds rate means a decreased opportunity to make money on interest. Newly issued Treasuries and annuities won’t pay off much. A decrease in interest rates will encourage investors to move money from the bond market to the equity market, which then begins to increase with the inflow of new capital.
What Happens When Interest Rates Drop?
When the economy slows, the Federal Reserve cuts federal funds rates to stimulate financial activity. The rate cut by the Fed has the opposite effect on rising interest rates. Investors and economists alike view lower interest rates as a catalyst for growth – benefits for personal and corporate lending, which in turn lead to bigger profits and a stronger economy. Consumers will spend more, the lower interest rates encourage them to feel that they can finally buy the new house or send the children to private schools; businesses will enjoy the ability to finance operations, acquisitions and expansions at lower rates, thereby increasing their potential future income, which, in turn, leads to higher share prices.
Specific winners of lower rate federal funds are dividend-paying sectors such as utilities and real estate investment trusts (REITs). In addition, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing.
Impact of Interest Rates on Shares
And by the way, nothing really happens to consumers or companies for the stock market to react to changes in interest rates. An increase or decrease in interest rates also affects investor psychology – and the market is meaningless if not psychological. When the Fed announces increases, businesses and consumers will cut spending; This will cause income to fall and share prices to fall, everyone thinks – and the market to vacillate in anticipation. On the other hand, when the Fed announces a cut, the assumption is that consumers and businesses will increase spending and investment, causing share prices to rise – and the market to soar with joy.
However, if expectations differ significantly from Fed action, this conventional general reaction may not prevail. For example, let’s say the word on the street is that the Fed will cut interest rates by 50 basis points at its next meeting, but the Fed announces a cut of only 25 basis points. The news could actually cause stocks to fall – assuming a 50 basis point cut was already in the market.
The business cycle, and where the economy is located, can also influence market reactions. In the early days of the weak economy, the modest boost provided by low interest rates was not enough to offset losses in economic activity, and stocks continued to decline. In contrast, towards the end of the boom cycle, when the Fed moves to raise interest rates – a nod to increase corporate profits – certain sectors often continue to do well, such as technology stocks, growth stocks and entertainment / leisure company stocks.
Base Line
Although the relationship between interest rates and the stock market is quite indirect, they tend to move in opposite directions: as a general rule of thumb, when the Fed cuts interest rates, it causes the stock market to rise; when the Fed raises interest rates, it causes the stock market as a whole to fall. But there are no guarantees about how the market will react to the specific interest rate changes the Fed chooses to make. For example, in 2013, contrary to conventional wisdom, interest rates and the S&P 500 increased significantly. Economists are still trying to think about it.
