How Interest Rates Impact the Stock Market

The more time you spend on trading and investment, the more you’ll find that rather than just watching the markets you’re anticipating how wider economic factors are going to influence them.

Because it’s so easy to think you’re seeing patterns that aren’t really there, you should be cautious about acting on them until you’ve figured out why they’re happening.

But something people do tend to notice quickly is that there’s a relationship between interest rates and the behavior of the stock market. What’s going on?

Why does that occur, and why doesn’t it seem to affect everything in the same way? What do you need to know about it to use it in your market predictions?

 

The Rate to Watch

The interest rate to watch in this situation is the federal funds rate, or overnight rate – the rate that governs how much it costs financial institutions to borrow money from the Federal Reserve.

This is the most powerful lever the government can use to keep the overall economy in balance, and adjusting it influences the rate of inflation. You can predict how it’s likely to change, most of the time if you follow how the wider economy is behaving and understand the government’s economic policy.

The federal funds rate is the single most important factor influencing the primary interest rate, which is the one that affects things like your personal mortgage rate and how much you pay on your credit card, as well as influencing how much it costs businesses to borrow money.

 

Rising Rates

When the federal funds rate rises, the stock market is impacted in two ways. Firstly, because it costs businesses more to borrow money, they concentrate on survival and less on growth – they are less likely to make speculative purchases and they take fewer risks.

Secondly, because ordinary people have to pay more for day to day necessities like mortgages and utilities, they have less discretionary income, so they buy less, which has a negative impact on the businesses that sell directly to them.

 

A Contrary Sector

There’s one sector that doesn’t behave the same way in response to rising rates, and that’s the finance sector, which can benefit from charging borrowers more (at least if the amount of capital such businesses lend during a high-interest rate period exceeds what they have to borrow from the Federal Reserve).

That means it can be a good idea to invest in financial stocks when you have reason to believe that the federal funds rate is about to rise.

 

Falling Rates

When the economy begins to slow, the government often decides to decrease the federal funds rate in order to encourage spending and thus increase overall financial activity.

That puts ordinary people in a position to spend more, which is good for businesses, and businesses benefit a second time because they can also borrow more cheaply.

That puts them in a position to be more productive and to grow and expand more effectively, as well as tolerating a greater degree of risk in their pursuit of opportunity.

As a result, they generally increase in value. Awareness of this can help you to identify good share tips. Larger companies that routinely carry a lot of debt benefit from the fact that it costs them less to service.

 

The Business Cycle

Although the above gives you a good general idea of how interest rates affect the stock market, there are other factors that can complicate the picture – most notably the point we’re at in the business cycle.

This is the natural expansion and contraction of the wider economy over time, as measured by the rise and fall in inflation-adjusted GDP. If the economy is weakening or potentially heading for recession, stock prices may continue to decline even if interest rates are lowered.

If, however, it has enjoyed a long period of steady growth, members of the public may have enough in their pockets that sectors dependent on casual spendings, such as entertainment, continue to do well for a while even if rates rise.

Familiarizing yourself with market responses like these can make it much easier to determine which stocks are likely to rise and fall in any given sector.

At the very least, it can help you to concentrate your focus on those sectors most likely to remain profitable when the overall market slumps, and it can give you a better idea of how to analyze the potential of individual companies’ stocks and shares, improving your ability to avoid losses and generate profits from your investments over time.