Interest rates are an element to be considered in the price of shares and the stock market. Although the relationship between the two may seem unclear, it is a very close relationship that needs to take into account.
When the FOMC decides on the target for the federal funds rate, there is a reaction throughout the country’s economy: the federal funds rate is the interest rate at which banks borrow money and lend to each other.
A curious fact is that, although the change takes place within one year, the effect on the economy is usually immediate.
Interest rates affecting the stock market
When the announcement of interest rate changes affects the country’s overall economy, it also impacts the stock market.
In the case of the US, the federal funds rate is the interest rate at which depository institutions will charge for loans they make with other entities. When one bank borrows money from another, this is the rate used as the “price” for the transactions.
Another important factor is that it is a measure used to contain inflation. The aim is to make the price of money more expensive, which means less money is available for purchases.
On the other hand, the interest rate will also be used as a benchmark for setting mortgage rates, credit card APRs and, in general, commercial and consumer lending rates.
What is the impact of rising interest rates on the economy?
The moment the Federal Reserve decides to raise the discount rate, the cost of short-term borrowing increases for banks and financial institutions,
What happens is that this effect is felt at all levels of the economy and especially by companies, which see how it has a direct impact on their financing needs.
The explanation is simple: if it costs the bank more to lend money, this extra cost will be charged to the company requesting financing. In other words, the cost of borrowing increases. In turn, companies pass on the rise in the final price of their products or services. This ends up reaching the consumer and the household economy.
If the domestic economy is affected, the natural effect is to reduce consumption. Lower spending, in turn, causes companies to make less money. If companies make less money, their share value tends to fall. And finally, if stocks go down, the stock market suffers, and the benchmark indices also go down.
In other words, companies are affected by a double effect in the case of rising interest rates:
- On the one hand, the difficulties in accessing finance and the higher cost of financing.
- On the other hand, the decrease in consumption and the loss of company value often lead to lower profits.
It is, then, a kind of domino effect that reaches all sectors and levels of the country’s economy. The stock market is therefore also affected.
Rising interest rates and the stock market
In the previous section, we have already seen that rising interest rates could result in companies losing value as they either increase debt or decrease revenues (or both).
When companies suffer this impact, the stock market is affected and hurts. It is usually reflected in the fall of benchmark indicators. Indices such as the Dow Jones (and others) decline and fall in value. In declining indices and stocks, average investors are not attracted to investment.
These are times when less advanced investors withdraw from investing in stocks and look for other, safer investments. This situation creates a falling market.
All this does not mean that all investors will retreat or lose, as there are sectors that identify positively with rising interest rates. For example, in the financial industry, banks’ profits generally increase, which can also extend to insurance companies.