Note that interest rates and the stock market share a notable relationship. Changes in the rates of interest and the movements in the stock market or the specific prices of individual stocks of publicly-traded companies are almost always related. Historical data shows that stock prices tend to go down whenever interest rates are high.
Apart from other factors affecting the stock market, several traders and investors, as well as fund managers and other professionals in the financial markets, have relied on current and future rates of interest set by a central bank or central monetary authority to guide their investment decisions, particularly when it comes to stocks trading or investing in the stock market.
What exactly is the relationship between interest rates and the stock market? How does the rise in these rates affect the performances of publicly-traded companies and the prices of their stocks? How do changes in interest rates affect stock trading?
Understanding the Relationship Between Interest Rates and the Stock Market: How Does The Rates of Interest Affect Stock Prices
Overview and Definitions
An interest rate is the amount a creditor or lender charges the borrower based on the percentage of the principal or the amount of money loaned due per period. For example, an interest rate of 1.50 percent and a loaned amount of USD 1000 means that the borrower must pay the lender a total amount of USD 1015 to settle his or her debt. Of course, it is important to note that most lenders give borrowers a fixed period of payment. The current interest rates are usually compounded each month or per annum.
Interest rates fall within the realms of the money market composed of financial institutions involved in providing credit or lending and trading services. Examples of money market instruments are bank deposits and certificates of deposits, treasury bills, commercial paper, and mortgage-backed and asset-backed securities, among others.
Note that information about the rates of interest is readily available through institutions such as banks and creditors. However, these institutions are not directly responsible for setting the prevailing rates in the entire money market. The central bank or a particular central monetary authority of a specific country sets interest rates for banks and other financial institutions as part of its monetary policy. These rates influence how much these financial institutions will charge their customers or their borrowers.
On the other hand, the stock market is an exchange market composed of sellers and buyers of stocks or shares. A stock represents ownership claim of a business or company. Not all companies are part of the stock market. Individuals and institutions can own stocks of so-called publicly-traded companies or businesses listed in a particular stock market.
Stock market participants often use different analytical tools and sources of market information to guide their trading and investment decisions. One of these is the prevailing interest rates and the prospects of these rates in the future. Understanding the relationship between interest rates and the stock market can help them understand better how changes in these rates can impact the performance of listed companies and their investments while also helping them make better trading and investment decisions.
Interest Rates and the Stock Market
Note that the accepted convention is that high interest rates result in low prices of stocks and reduced perceived stock market performance. On the other hand, when the interest rates fall, the stock market tends to take off and the prices of stocks tend to follow an upward trend. These phenomena have been observed in numerous real-world scenarios.
However, it is important to note that the relationship between interest rates and the stock market or the specific prices of individual stocks is not direct. The changes in the rates of interest result in different outcomes that affect the supply and circulation of money in an economy, the pattern of consumption, and the performance and decisions of companies.
The relationship between the two is fundamentally inverse but indirect. The following are the explanations detailing how interest rates affect the stock market:
Effects on Spending Power and Consumption Pattern
Consumption can help understand better the relationship between interest rates and the stock market or to understand how changes in interest rates affect the prices of specific stocks. Note that the rates of interest influence the spending power of individuals and households, as well as the patterns of consumption in a particular economy.
Remember that central banks or monetary authorities use interest rates as a monetary policy tool. These regulatory bodies impose lower rates during economic downturns to increase the money supply in circulation, promote consumption, and stimulate economic activity. They impose rate hikes in several situations to control inflation by reducing the money supply in circulation or prevent the economy from overheating due to rapid economic growth
Low interest rates encourage banks and other financial institutions to borrow money from a central bank or monetary authority. These institutions use low-cost borrowed money to bring down their own interest rates and entice customers to borrow from them, thus effectively promoting and increasing public access to credit.
Nevertheless, whenever interest rates are low, the public has more money to spend on consumer goods and businesses have better access to loans needed to sustain or expand their operations. However, the exact opposite happens whenever interest rates are high.
High interest rates discourage the public from accessing credit and dampen overall consumption activity. These rate hikes also reduce activities related to business expansion. Weak spending power and low consumption mean that businesses have less income and have lower prospects for maximizing and growing their business potential.
Impact on Business Decision and Company Performance
The aforementioned effects on spending power and consumption pattern also relate to specific impacts on business decisions and company performance. Of course, because low interest rates stimulate consumption activity, the profitability of businesses increases. The opposite happens when interest rates are high and consumption is low.
Low profitability indicates that a particular company is not performing as it should. For companies listed on a stock exchange, this signals traders and investors to avoid buying stocks. Even announcements about looming interest rate hikes compel traders and investors to either avoid buying stocks or dump the stocks they own. Low demand for stocks and widescale instances of stock dumping and short selling drive down the price of stocks.
It is also important to note that high interest rates mean that the cost of borrowing for businesses increases. Higher borrowing rates usually affect the profit margins of these businesses while also affecting their ability to raise capital for expansion purposes.
Prolonged periods of high interest rates ultimately cause the stock market to move on a downward trend. The combination of low consumption, investment sentiments, increased cost of borrowing, and reduced access to capital from stocks and debt negatively impact the capability of a publicly-traded company to generate profits and expand.
Reactions from Individual and Institutional Investors
It is also important to reiterate the reactions from and sentiments of individual and institutional traders and investors to understand better the relationship between interest rates and the stock market, especially when it comes to the impacts of these rates on stock prices.
Remember that high interest rates can affect the profitability of publicly traded companies. Forthcoming interest rate hikes encourage several traders and investors to avoid buying stocks or dump the stocks they own to minimize or even avoid their losses. Interest rates are fundamental stock price signals influencing trading and investment decisions.
Furthermore, interest rates can also be a macroeconomic indicator of overall economic health. High interest rates are indicative of an overactive economy or a prevailing problem with high inflation rates. Imminent rake hikes are also an indicator that the government and its regulatory arm are bracing for an economic slowdown due to nearing overheating.
Some traders and investors would shift their attention toward moderate and more conservative securities and other financial instruments. Investing in the stock market and trading stocks are generally high-risk investment and trading activities.
Another impact of high interest rates is that it increases the cost of borrowing activities of companies and the overall costs of doing business. Increases in these costs can affect how traders and investors perceive and value publicly-traded companies.
More on the Relationship Between Interest Rates and the Stock Market: A Note on Generalizations and Considerations
The notion that the interest rates and the stock market have an inverse relationship is a generally accepted principle in macroeconomics and finance. To summarize, high interest rates tend to result in low stock prices and negatively affect the performance of the stock market.
High interest rates discourage consumption and affect the profitability of businesses, restrict access to capital and affect the expansion plans of these businesses, indicate prevailing and forthcoming economic issues, and affect the overall sentiments of traders and investors. The opposite tends to happen when interest rates are low.
But the aforementioned notion is still a generalization. The fact is that interest rates do not affect all publicly-traded companies. Some of these companies even benefit during periods of high interest rates. There are also several instances when different stock indexes remained unaffected during periods when interest rates were high.
Specific institutions in the finance sector such as banks and creditors, insurance companies, and asset management firms usually have a positive relationship with interest rates. These companies benefit whenever interest rates are high because they can charge more and increase their profitability, thereby making them attractive to traders and investors.
Companies that sell staples or consumer goods have mixed performances. Some producers of food and beverage products tend to be unaffected because they can pass on the increased cost of borrowing to the consumers. Consumer goods are also fast-moving products and most individuals and households consider them necessities.
However, several companies in the technology industry, especially those operating in the consumer electronics market, can be negatively affected by high interest rates. Products such as laptops or smartphones are not staple goods.
