Generally, interest rates and the stock market have an inverse relationship. When interest rates rise, share prices fall. Bonds become more attractive. When interest rates rise, it can make borrowing money for a company more expensive, which means they have less money to invest back in the company and less cash flow stability, which typically puts pressure on share prices. When interest rates fall, the inverse is true for all of the above.
Key Takeaways
- When the Federal Open Market Committee (FOMC) changes the interest rate, it impacts both the economy and the stock markets because borrowing becomes either more or less expensive for individuals and businesses.
- Any impact on the stock market to a change in the interest rate is generally experienced immediately, while, for the rest of the economy, it may take about a year to see any widespread impact.
- Higher interest rates tend to negatively affect earnings and stock prices (with the exception of the financial sector).
- Higher interest rates also mean future discounted valuations are lower as the discount rate used for future cash flow is higher.
- To shield from risk, investors may consider opting for shorter-term bonds or shorter life alternative assets.
Interest Rates: An Overview
While it usually takes at least 12 months for a change in the interest rate to have a widespread economic impact, the stock market's response to a change is often more immediate. Markets will often attempt to price in future expectations of rate hikes and anticipate the actions of the FOMC.
Besides thefederal funds rate, theFederal Reservealso sets adiscount rate. The discount rate is the interestrate the Fedcharges banks that borrow from itdirectly. Thisratetends to be higher than thetarget federal funds rate (in part, to encourage banks to borrow from other banks at the lowerfederal funds rate).
Understanding the relationship between interest rates and the stock marketcan help investors understand how changes may impact their investments. They can also be better prepared to make better financialdecisions.
The Federal Funds Rate
The interest rate that impacts the stock market is the federal funds rate. The federal funds rate is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans (whereas the discount rate is theinterest ratethat Federal Reserve Banks charge when they make collateralized loans—usually overnight—to depository institutions).
The Federal Reserve influences the federal funds rate in order to control inflation. By increasing the federal funds rate, the Federal Reserve is effectively attempting to shrink the supply of money available for making purchases. This, in turn, makes money more expensive to obtain. Conversely, when the Federal Reserve decreases the federal funds rate, it increases the money supply. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns.
The federal funds rate is significant because the prime interest rate—the interest rate commercial banks charge their most credit-worthy customers—is largely based on the federal funds rate. It alsoforms the basis for mortgage loan rates, credit card annual percentage rates (APRs), and a host of other consumer and business loan rates.
What Happens When Interest Rates Rise?
When the Federal Reserve acts to increase the discount rate, it immediately elevates short-term borrowing costs for financial institutions. This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy.
Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So individual consumers are impacted by increases in their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.
Consumers still have to pay their bills. When those bills become more expensive, households are left with less disposable income. When consumers have less discretionary spending money, businesses' revenues and profits decrease.
So, as you can see, as rates rise, businesses are not only impacted by higher borrowing costs but they are also exposed to the adverse effects of flagging consumer demand. Both of these factors can weigh on earnings and stock prices.
What Happens When Interest Rates Fall?
When the economy is slowing, the Federal Reserve cuts the federal funds rate to stimulate financial activity. A decrease in interest rates by the Federal Reserve has the opposite effect ofa rate hike. Investors and economists alike view lower interest rates as catalysts for growth—a benefit to personal and corporate borrowing. This, in turn, leads to greater profits and a robust economy.
Consumers will spend more, with the lower interest rates makingthemfeel that, perhaps, they can finally afford to buy that new house or send their kids to a private school. Businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential. This, in turn, leads to higher stock prices.
Particular winners of lower federal funds rates are dividend-paying sectors, such as utilities and real estate investment trusts (REITs). Additionally, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing.
Interest Rates and the Stock Market
If a company is seen as cutting back on its growthor isless profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company's stock.
If enough companies experience declines in their stock prices, the whole market, or the key indexes many people equate with the market—the Dow Jones Industrial Average,S&P 500, etc.—will go down. With a lowered expectation in the growth and future cash flows of a company, investors will not get as much growth from stock price appreciation. This can make stock ownership less desirable. Furthermore, investing in equities can be viewed as too risky when compared to other investments.
However, some sectors stand to benefit from interest rate hikes. One sector that tends to benefit the most is the financial industry. Banks, brokerages, mortgage companies, and insurance companies' earnings often increase—as interest rates move higher—because they can charge more for lending.
Interest Rates and the Bond Market
Interest rates also impact bond prices and the return oncertificates of deposit (CDs),Treasury bonds, and Treasury bills. There is an inverse relationship between bond prices and interest rates: as interest rates rise, bond prices fall (and vice versa). The longer the maturity of the bond, the more it fluctuates in accordance with changes in the interest rate.
When the Federal Reserve raises the federal funds rate, newly offered government securities—such as Treasury bills and bonds—are often viewed as the safest investments. They will usually experience a corresponding increase in interest rates. In other words, the risk-free rate of return goes up, making these investments more desirable.
As the risk-free rate goes up, 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 dipslower), investors may feel stocks have become too riskyand will put their money elsewhere.
The measure of the sensitivity of a bond's price to a change in interest rates is called the duration.
One way governments and businesses raise money is through the sale of bonds. As interest rates rise, the cost of borrowing becomes more expensive for them, resulting in higher-yielding debt issuances. Simultaneously, market demand for existing, lower-coupon bonds will fall (causing their prices to drop and yields to rise).
Conversely, as interest rates fall, it becomes easier for entities to borrow money, resulting in lower-yielding debt issuances. Simultaneously, market demand for existing, higher-coupon bonds will increase (causing their prices to rise and yields to fall). Incidentally, in this type of environment, issuers of callable bonds may choose to refinance them and lock in the prevailing lower rates.
For income-oriented investors, a reduction in the federal funds ratemeans a decreased opportunity to make money from interest. Newly-issued treasuries and annuities won't pay as much. A decrease in interest rates will prompt investors to move money from the bond market to the equity market. The influx of new capital causes the equity market to rise.
Impact of Expectations
Nothing has to actually happen to consumers or companies for the stock market to react to interest-rate changes. Rising or falling interest ratescan also impact the psychology of investors. When the Federal Reserve announces a hike, both businesses and consumers will cut back on spending. Thiswill cause earnings to fall and stock prices to drop, and the market may tumble in anticipation.
On the other hand, when the Federal Reserve announces a cut, the assumption is consumers and businesses will increase spending and investment. This can cause stock prices to rise.
If expectations differ significantly from the Federal Reserve's actions, these generalized, conventional reactions may not apply. For example, suppose that the Federal Reserve is expected to cut interest rates by 50 basis points at its next meeting, but they instead announce a drop of only 25 basis points. The news may actually cause stocks to declinebecause the assumption of a cut of 50 basis points had already been priced into the market.
The FOMC increased the fed funds rate over time from 0.20% in March 2022 to 5.08% in June 2023 in order to combat high inflation.
The business cycle, and where the economy is in it, can also affect the market's reaction. At the onset of a weakening economy, a modest boost provided by lower interest rates is not enough to offset the loss of economic activity; stocks may continue to decline. Conversely, toward the end of a boom cycle, when the Federal Reserve is moving in to raise rates—a nod to improved corporate profits—certain sectors often continue to do well, such as technology stocks, growth stocks, and entertainment and recreational company stocks.
What Stocks Go Up When Interest Rates Go Up?
When interest rates go up, the Federal Reserve is attempting to cool an overheating economy. By making credit more expensive and harder to come by, certain industries such as consumer goods, lifestyle essentials, and industrial goods sectors that do not rely on economic growth may be poised for future success. In addition, any company that is not reliant on growth through low-cost debt can go up along with interest rates as it does not require external costly financing for expansion.
What Happens to Growth Stocks When Interest Rates Rise?
Growth stocks are heavily reliant on capital for future business expansion. During periods of low interest rates, it's the golden age for growth stocks as capital can be obtained cheaply and growth easier to come by. Therefore, as interest rates rise, many investors believe growth stocks are less favorable because their long-term discounted cash flow is reduced and their ability to secure low-cost debt financing is more difficult.
What Is the Best Investment When Interest Rates Are Rising?
All macroeconomic situations are different, so there is no single best investment suitable for all investment conditions. With that said, some investment classes do tend to perform better when interest rates are rising. There is more risk of locking into long-term rates, so shorter-term bonds are often preferable. If rising rates are in response to inflation, you may consider inflation-specific government bonds. Lastly, if you believe interest rates will have a detrimental impact on equities, you may consider shorting the stock market. For direct investment guidance, please consult your financial advisor.
The Bottom Line
Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there isno guarantee as to how the market will react to any given interest rate change.
