Understanding the effect of interest rates on the stock market

When you start investing, it’s important to understand what guides the stock market. One key factor is the effect of interest rates on the stock market. A country’s central bank sets these rates, which affect how much it costs to borrow money. This, in turn, impacts businesses, investors, and the whole economy.

Knowing how interest rates affect stocks isn’t just helpful—it’s key to making smart financial choices. Think of interest rates as the heartbeat of finance. They affect how easily businesses can borrow money, which in turn affects their ability to grow, create new things, and make profits.

For investors, changes in interest rates often lead to changes in stock prices. As rates go up or down, so do many stocks, reflecting the ups and downs of the economy.

In this article, we’ll break down the impact of interest rates on the stock market in a simple and accessible way, using real-world examples to enhance understanding.

Summary highlights:

• The central bank’s benchmark interest rate, guided by the central banking authority of a country, holds a pivotal role in influencing interest rates and subsequently impacting the stock market.
• Rising interest rates can increase borrowing costs for businesses, potentially affecting their profits and stock values.
• Conversely, falling interest rates can stimulate economic activity, benefiting businesses and contributing to higher stock prices.
• Different sectors respond uniquely to interest rate changes, with the financial industry often benefiting from higher rates.
• Bond prices and interest rates maintain an inverse relationship: as rates rise, bond prices tend to fall, and vice versa.

The central bank’s benchmark interest rate:

At the heart of this relationship is the central bank’s benchmark interest rate. This rate influences how much banks charge each other for short-term loans, and when adjusted, it affects the entire economy and the stock market.

When the central bank raises its benchmark rate, it aims to reduce the money supply, making borrowing more expensive. Conversely, lowering the rate increases the money supply, encouraging spending by making borrowing cheaper.

The manipulation of interest rates is a delicate tool used by central banks to strike a balance between promoting economic growth and controlling the effect of interest rates on inflation. However, this strategy comes with its own challenges, as raising rates too much can slow economic activity, while keeping rates low for too long can cause inflation.

Additionally, the global economy is interconnected, so changes in one country’s interest rates can affect international currency values, trade balances, and investments. This underscores the complex web of global economic relationships.

Federal funds rate – 20 year historical chart

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Did you know?

Starting from March 2022, the Federal Open Market Committee (FOMC) gradually raised the Fed funds rate, moving it from near zero to 5.33% by July 2023, as part of efforts to address elevated inflationary pressures.

Although it typically requires a year for a shift in interest rates to exert a broad economic influence, the stock market tends to react more promptly. Markets frequently endeavour to factor in future anticipations of rate hikes and forecast the actions of the FOMC.

How interest rates affect stock markets

Rising interest rates

When a central bank raises interest rates, it becomes more expensive for companies to borrow money. This leads to higher costs for businesses, impacting their profits.

Meet Baker’s Delight: Imagine Baker’s Delight, a small bakery chain with dreams of expanding. When the central bank raises interest rates, borrowing becomes pricier for businesses like Baker’s Delight. The increased cost of funds for expansion could potentially squeeze the company’s profits and impact the value of its stocks on the market.

Consumers also bear the brunt when financial institutions grappling with higher borrowing costs pass on the burden to borrowers. As interest rates climb, especially on variable-rate loans like credit cards and mortgages, individuals face the heat with increased monthly payments, leaving them with less money to spend. Moreover, while the goal is to discourage borrowing, higher rates also aim to encourage saving.

While consumers grapple with mounting bills, businesses, too, are caught in the crossfire. As households trim discretionary spending due to higher expenses, businesses witness a decline in revenues and profits. This interplay creates a challenging cycle: reduced consumer spending triggers a downturn for businesses, leading them to curtail expansion plans and further exacerbating the economic strain.

Falling interest rates

Conversely, when interest rates fall, borrowing becomes cheaper. This stimulates economic activity as businesses benefit from more cost-effective financing options for operations, acquisitions, and expansions, ultimately bolstering their potential for future earnings growth.

Consumers may find themselves more inclined to increase spending, perceiving greater affordability for significant investments like buying a new home or enrolling their children in private education. Consequently, this positive economic cycle tends to drive stock prices higher.

The Johnsons’ Dream Home: Now, consider the Johnson family. With lower interest rates, they find it more affordable to buy their dream home. This not only boosts the housing market but also benefits companies in construction and real estate, amongst others.

How do interest rates affect different types of stocks?

When interest rates rise or decline, certain types of stocks tend to perform well. Here are some categories of stocks that are generally considered to benefit or be adversely affected by changes in interest rates.

Growth stocks

Firstly, growth stocks, which belong to rapidly expanding industries driven by innovation, are heavily influenced by rising interest rates. These companies prioritise revenue growth over immediate profitability, making them more sensitive to higher rates.

Since they depend on future cash flows discounted heavily, their valuations are more impacted by rising interest rates. Additionally, these early-stage firms often rely on credit, so increased borrowing costs can hinder their growth. Higher interest rates may also lead to a decline in economic growth, affecting returns for these companies.

Technology giant Tesla Inc. (TSLA) began its journey as a growth stock. Over the past few years, Tesla has concentrated on expanding its market share and investing heavily in innovative technologies, marking it as a prime example of a company that initially embraced a growth-oriented strategy.

Value stocks

Value stocks, known for their stable business models generating steady revenue and earnings, experience less volatility during rising rates. Many value stocks pay dividends, making them attractive to investors seeking income stability during turbulent times.

Similarly, when interest rates are low, these stocks paying consistent dividends become relatively more attractive. Investors seeking income may turn to dividend-paying stocks as an alternative to fixed-income investments.

An additional characteristic of value stocks is that they typically trade at a lower price relative to their fundamental metrics, including dividends, earnings, and sales. This valuation aspect further underscores the appeal of value stocks, offering investors the potential for both income and the opportunity for capital appreciation based on solid fundamentals.

Procter & Gamble (PG) is often regarded as a value stock. It’s a stable consumer goods company with predictable cash flows and dividends. During times of economic uncertainty, investors often turn to such stocks for their reliability.

Cyclical stocks

The third category includes cyclical companies, such as restaurants and retail businesses, thriving during economic expansions but suffering when spending diminishes due to reduced money supply.

Marriott International (MAR), a hotel chain, exemplifies a cyclical stock. During periods of economic expansion, people tend to travel more, benefiting hotel chains. Conversely, during economic downturns, travel decreases, impacting the earnings of companies like Marriott.

Defensive stocks

Defensive stocks, like utilities and pharmaceuticals, are favoured during falling, stable and rising rates. These companies provide products essential to consumers regardless of economic conditions, making them less sensitive to economic cycles.

Johnson & Johnson (JNJ) is a classic defensive stock in the pharmaceutical sector. Regardless of economic conditions, the demand for healthcare products remains relatively stable. Johnson & Johnson is known for its resilience during economic downturns, making it a defensive stock.

Real Estate Investment Trusts (REITs)

REITs, especially those focused on income-producing properties like residential or commercial real estate, often benefit from lower interest rates. As borrowing costs decrease, REITs can refinance debt at more favourable terms.

Simon Property Group (SPG), specialising in retail real estate, is a REIT that may benefit from lower interest rates. As borrowing becomes more affordable, Simon Property Group could seize opportunities for favourable refinancing, contributing to its overall financial well-being.

The interplay between interest rates, bonds, and stocks

Changes in interest rates, bonds, and stock prices all affect each other. When interest rates go up, older bonds usually lose value. Why? Because new bonds start offering higher returns to match the higher rates. This makes older bonds with lower returns less appealing. As these older bonds lose value, they start offering better returns, which can make some investors prefer them over stocks.

Moreover, the impact of interest rates extends to the stock market. The risk-free rate serves as a benchmark, typically reflecting the yield on government bonds considered to have minimal default risk.

As the risk-free rate climbs, the total return expected for investing in stocks also increases. Consequently, if the required risk premium decreases and the potential return on stocks remains static or declines, investors may perceive equities as riskier.

This shift in perception prompts investors to reevaluate their portfolio allocations, leading them to redirect funds to alternative assets deemed less risky in the changing interest rate landscape. In this delicate balance, the ebb and flow of interest rates play a pivotal role in shaping investor sentiment and influencing both bond and stock markets.

Conclusion

Understanding the relationship between interest rates and the stock market is fundamental for anyone navigating the world of investments. Whether rates are rising or falling, their impact is far-reaching, influencing the decisions of businesses, consumers, and investors alike.

By considering these dynamics and examples, beginners can make more informed choices in their investment journey.