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.