Everything The Trader Needs To Know About Interest Rates

By April 18, 2018Trader Tips

How Interest Rates Affect Investments and Stock Prices

Over the past six months, a good part of the financial news has been about when the Federal Reserve would make its next interest rate hike.  

In June, the Federal Reserve (Fed) increased the key interest rate—the so-called Fed fund target rate–for the second time this year and for the third time in six months and kept outlook unchanged for one more interest rate hike until the end of 2017.   

Typically, an interest rate hike by monetary policymakers at the Fed means that they have a positive outlook on the economy in the short term—they are looking at jobs reports, inflation rates, and economic growth when they set the key interest rate. That rate is important because most banks follow the Fed’s lead in adjusting the interest rates that they charge to clients.

So far, so good. But how do interest rates impact our investments, stock prices, and the stock market as a whole?

Here’s our short guide on what to expect when interest rates change.

When interest rates rise, people and companies pay more interest. This means that you’ll be paying more on your credit cards and mortgage loans, and businesses will pay more to get loans. A higher interest rate means that it will cost more to borrow money.

This higher costs for borrowing goes for consumers as well as for companies. This, in turn, leads to consumers and reconsider their spending and investment decisions. Higher interest leads to lower spending, and the other way around – lower interest rates spur more spending on goods and services.

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Changes in interest rates do not directly affect the stock market, but they affect the listed companies’ cost of borrowing money, their cost of capital. And if companies have to pay more interest, this additional money may eat up some of their profits and cause the stock price to drop.

In the reverse scenario, when interest rates fall, borrowing becomes cheaper for companies. If investors think that the firm will spend less of its revenue on interest payments, this may cause its stock price to increase because earnings and earnings expectations may be higher.

With lower interest rates, both consumers and companies are paying less for borrowing, so the typical financial theory view is that lower interest rates lead to higher spending. The lower cost to borrow money leads to businesses paying less for interest and less for the debt they take on to expand their operations or finance acquisitions. This leads to assumptions that their future earnings will grow, which leads to higher stock prices.

In the case of higher interest rates, companies may scale back purchase plans and spending on growth. If investors believe that a company will make less profit because of higher spending on interest and debts, its stock price will fall.

However, at higher interest rates, one sector tends to benefit – the financial sector. That’s because banks, brokerages, and insurers charge more for lending to consumers and companies as they align their interest rate trends to the key Fed rate. That means that the banks’ revenues from fees rise.

In the current Fed policy for interest rate hikes, the stock market has not dropped, as the financial theory would suggest. It’s not the first time in history that stocks have rallied alongside gradual increases in Fed’s key rates.

Interest rates and the stock market tend to go in the same direction over the long term because the Fed raises rates when it expects the economy to be in a good shape – and a growing economy also leads to bull markets.

Everything The Trader Needs To Know About Interest RatesSource: MarketWatch via FactSet

In addition, the current rates at 1 percent to 1.25 percent are close to historic lows. The all-time low was 0.25 percent – the lowest fed funds rate possible — effectively zero. The Fed lowered it to this level in December 2008 during the crisis and didn’t raise rates until December 2015.

Between 1971 and 2017, interest rates in the U.S. averaged 5.79 percent, with an all-time high of 20 percent in March 1980 and the December 2008 record low of 0.25 percent.

Everything The Trader Needs To Know About Interest RatesSource: Trading Economics

 

So, to sum up – the financial theory goes that higher interest rates lead to lower stock prices because companies pay more to borrow money to expand, and may see lowered profits due to this.

However, there is a time lag of some 12 months before higher interest rates affect stock prices. Not all companies see their profits and stock values shrink because the cost of capital is just one of many metrics that inventors use to evaluate if companies and their stock prices have growth potential.

Interest rate hikes do not directly impact inversely the stock market. Stocks may continue to rally because strong economy – which makes the Fed raise rates – suggests greater corporate profits and a bull market.  

 

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