How Interest Rates Affect The Stock Market

2012-02-29 12:14:05

May 26 2009 | Filed Under Bonds , Economics , Options

Interest rates. Most people pay attention to them, and they can impact the

stock market. But why? In this article, we'll explain some of the indirect

links between interest rates and the stock market and show you how they might

affect your life.

The Interest Rate

Essentially, interest is nothing more than the cost someone pays for the use of

someone else's money. Homeowners know this scenario quite intimately. They have

to use a bank's money (through a mortgage) to purchase a home, and they have to

pay the bank for the privilege. Credit card users also know this scenario quite

well - they borrow money for the short term in order to buy something right

away. But when it comes to the stock market and the impact of interest rates,

the term usually refers to something other than the above examples - although

we will see that they are affected as well. (To read more, see Who determines

interest rates?)

The interest rate that applies to investors is the U.S. Federal Reserve's

federal funds rate. This is the cost that banks are charged for borrowing money

from Federal Reserve banks. Why is this number so important? It is the way the

Federal Reserve (the "Fed") attempts to control inflation. Inflation is caused

by too much money chasing too few goods (or too much demand for too little

supply), which causes prices to increase. By influencing the amount of money

available for purchasing goods, the Fed can control inflation. Other countries'

central banks do the same thing for the same reason.

Basically, by increasing the federal funds rate, the Fed attempts to lower the

supply of money by making it more expensive to obtain.(To see more on the

Federal Reserve, read Get To Know The Major Central Banks, The Fed Model And

Stock Valuation: What It Does And Does Not Tell Us and Formulating Monetary

Policy.)

Effects of an Increase

When the Fed increases the federal funds rate, it does not have an immediate

impact on the stock market. Instead, the increased federal funds rate has a

single direct effect - it becomes more expensive for banks to borrow money from

the Fed. However, increases in the discount rate also cause a ripple effect,

and factors that influence both individuals and businesses are affected.

The first indirect effect of an increased federal funds rate is that banks

increase the rates that they charge their customers to borrow money.

Individuals are affected through increases to credit card and mortgage interest

rates, especially if they carry a variable interest rate. This has the effect

of decreasing the amount of money consumers can spend. After all, people still

have to pay the bills, and when those bills become more expensive, households

are left with less disposable income. This means that people will spend less

discretionary money, which will affect businesses' top and bottom lines (that

is, revenues and profits).

Therefore, businesses are also indirectly affected by an increase in the

federal funds rate as a result of the actions of individual consumers. But

businesses are affected in a more direct way as well. They, too, borrow money

from banks to run and expand their operations. When the banks make borrowing

more expensive, companies might not borrow as much and will pay a higher rate

of interest on their loans. Less business spending can slow down the growth of

a company, resulting in decreases in profit. (For extra reading on company

lending, read When Companies Borrow Money.)

Stock Price Effects

Clearly, changes in the federal funds rate affect the behavior of consumers and

business, but the stock market is also affected. Remember that one method of

valuing a company is to take the sum of all the expected future cash flows from

that company discounted back to the present. To arrive at a stock's price, take

the sum of the future discounted cash flow and divide it by the number of

shares available. This price fluctuates as a result of the different

expectations that people have about the company at different times. Because of

those differences, they are willing to buy or sell shares at different prices.

If a company is seen as cutting back on its growth spending or is making less

profit - either through higher debt expenses or less revenue from consumers -

then 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 a decline in their stock prices, the whole market, or the indexes

(like the Dow Jones Industrial Average or the S&P 500) that many people equate

with the market, will go down. (To learn more, check out Why Do Markets Move?,

Forces That Move Stock Prices and What causes a significant move in the stock

market?)

Investment Effects

For many investors, a declining market or stock price is not a desirable

outcome. Investors wish to see their invested money increase in value. Such

gains come from stock price appreciation, the payment of dividends - or both.

With a lowered expectation in the growth and future cash flows of the company,

investors will not get as much growth from stock price appreciation, making

stock ownership less desirable.

Furthermore, investing in stocks can be viewed as too risky compared to other

investments. When the Fed raises the federal funds rate, newly offered

government securities, such Treasury bills and bonds, are often viewed as the

safest investments and 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. When people invest in stocks, they need to be

compensated for taking on the additional risk involved in such an investment,

or a premium above the risk-free rate. The desired return for investing in

stocks is the sum of the risk-free rate and the risk premium. Of course,

different people have different risk premiums, depending on their own tolerance

for risk and the company they are buying. However, in general, 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 becomes lower, investors might feel that stocks have become

too risky, and will put their money elsewhere.

Interest Rates Affect but Don't Determine the Stock Market

The interest rate, commonly bandied about by the media, has a wide and varied

impact upon the economy. When it is raised, the general effect is to lessen the

amount of money in circulation, which works to keep inflation low. It also

makes borrowing money more expensive, which affects how consumers and

businesses spend their money; this increases expenses for companies, lowering

earnings somewhat for those with debt to pay. Finally, it tends to make the

stock market a slightly less attractive place to investment.

Keep in mind, however, that these factors and results are all interrelated.

What we described above are very broad interactions, which can play out in

innumerable ways. Interest rates are not the only determinant of stock prices

and there are many considerations that go into stock prices and the general

trend of the market - an increased interest rate is only one of them.

Therefore, one can never say with confidence that an interest rate hike by the

Fed will have an overall negative effect on stock prices.

To read further on interest rates, see Trying To Predict Interest Rates, Forces

Behind Interest Rates and Dividends, Interest Rates And Their Effect on Stock

Options.