Understanding how interest rates affect the stock market
Interest rates can influence nearly every part of your financial life. They also help determine the behavior of investors as well as consumers, and companies. Of these groups, investors tend to be the most sensitive to news surrounding interest rates and their movements because of how it can affect different assets and what it signals for the market as a whole.
How interest rates work
Interest rates are the amount a lender charges a customer for borrowing money. These rates can show up in several places in your day-to-day life. "Interest rates don't only impact the stock market. The rates we pay for things like mortgages, student loans and even credit cards follow the path of federal interest rates," says Brenton Harrison, CFP® professional based in Nashville, TN.
The Federal Reserve, also known simply as "the Fed" plays a major role in setting the benchmark for which all major loans, bonds, and savings accounts are based. This is called the federal funds rate, which is the interest rate banks charge when they lend money to each other. When this rate increases, it makes borrowing more expensive and results in higher interest cost being levied on other financial transactions like mortgage loans but also higher interest rates on savings accounts. When interest rates are reduced, the opposite occurs for savings and loans.
The relationship between interest rates and inflation
Changing interest rates is one of the main tools that the Fed can use to cool down inflation.
Inflation is the increase in the prices of goods and services over time and occurs when the demand for those goods and services exceeds supply.
Typically, the Fed raises interest rates in times of economic expansion and does so to prevent the economy from overheating. The opposite is true when interest rates are cut, which typically occurs when the economy is in a down trend.
This encourages investors to spend more and borrow to expand the economy but if the economy expands too quickly, then inflation becomes an issue. The Fed has the difficult job of finding the right mix to foster economic stability. The Fed usually raises interest rates to discourage borrowing and reduce demand, this lower demand often results in lower prices.
"When interest rates are high, individuals may decide to just keep money in a savings account or bonds and be paid more for taking little risk," says Dr. Hans Boateng, founder of The Investing Tutor. This causes money to move from riskier based equities into safer investments with higher yield," he adds.
How interest rates affect the stock market
To understand how interest rates can affect the stock market it is important to understand the macro perspective before narrowing down to certain sectors of the stock market to see where some areas could vary more than others.
The Fed meets eight times per year to discuss the federal funds rate, and investors tend to react to what occurs once the notes of the meeting have been released. During these meetings, the Fed uses economic data like the Consumer Price Index (CPI), the unemployment rate, and more to determine what the Fed Funds rate should be.
The stock market reacts to the changes in the interest rates because it generally signals whether or not the economy is strong. It could also have an impact on a company's cost to doing business, thus changing how investors may value a company. This is because of the impact that interest rates have on the stock market.
Here are the ways interest rates affect the stock market:
1. When rates rise, stocks tend to fall — and when rates rise, stocks tend to fall.
"When interest rates are low, companies can assume debt at a low cost, which they may use to add team members or expand into new ventures," says Harrison. "When rates rise, it's harder for companies to borrow and more costly to manage what debt they already have, which impacts their ability to grow," he adds. These higher costs may result in lower revenues, thus negatively impacting the value of the company.
Also keep in mind that as rates fall on savings accounts and certificates of deposit, investors generally seek out higher paying investments like stocks and are generally seen as a catalyst for growth in the market; in a rising rate environment investors tend to shift away from stock to places with less risk and safer returns.
2. The rates impacts bonds.
Most traditional bonds pay a fixed interest rate through maturity. For example, if you own a 10 year bond paying 3% per year, the 3% annual payment will not fluctuate. However, if interest rates are cut during the life of the bond, the value of the bond rises. This is because as new bonds are issued, it is unlikely that they will be as attractive financially. The opposite is true in a rising rate environment.
3. Investor expectations can cause volatility.
In some cases, how investors feel about the prospects of an interest rate hike or cut can cause the market to swing. Due to announcements by the Fed and other economic data, investors may anticipate a threat of rising rates and begin selling causing short termvolatility. This was the case at various points in 2018 and 2021. Investors can do the same and expect a drop in interest rates. In either case, the market can react simply to these expectations of a change in rates without the Fed actually making a move.
While it is broadly true that the stock market and interest rates have an inverse relationship, certain areas of the market may react differently. This is because as rates rise, investors tend to look for higher-paying dividends and areas that are considered safer bets.
Additionally, sectors of the stock market that rely on debt financing are particularly sensitive to changes in interest rates while sectors that are more established, with positive cash flows tend to be more insulated from interest rate risks.
The bottom line
Changing interest rates can cause volatility in the stock market but the key is to remain focused on your long term financial goals. "If you've found a long-term investment strategy you believe in, continue to invest — and remain invested — regardless of what happens in the short term," says Harrison.Kevin L. Matthews IIKevin L. Matthews II is a No. 1 bestselling author and former financial advisor. He has helped hundreds of individuals plan for their retirement in addition to managing more than $140 million in assets during his advisory career. In 2017, he was named one of the Top 100 Most Influential Financial Advisors by Investopedia. Kevin holds a bachelor's degree in Economics from Hampton University and a certificate in financial planning from Northwestern University. In 2020, he graduated from the University of Texas at Austin with a Master's in Technology Commercialization (MSTC).