You’ve probably seen the news about interest rates popping up all over financial news in recent months. There’s a very good reason for this. It affects the stock market in several different ways.
A change in interest rates can affect nearly every part of the US and global economy.
How Do Interest Rates Affect The Stock Market?
Very simply, interest rates have a direct effect on the demand for goods and services in the economy. When prices go up due to interest rates, demand tends to go down.
When demand goes down, the stock prices tend to drop as this leads to a decrease in revenue and future earnings.
Let’s dig a bit deeper into this to help explain.
What Is The Federal Funds Rate?
The interest rate is referred to as the US Federal Reserve’s Federal Funds Rate. This is the interest rate the Federal Reserve charges banks and institutional trading firms to borrow money.
They usually borrow money in the very short term, sometimes overnight, but they are usually borrowing billions of dollars.
While the interest rate is currently set to 0-0.25%, even the top of the range at 0.25% on a $50 million loan from the Fed would cost $125,000 just for the interest.
That’s assuming it’s held for the whole year.
Why Does It Matter?
Banks lend money to everyone from huge commercial businesses to you and me.
Since they’re in business to make money, it stands to reason that their income would be pegged closely to how much they have to pay the Fed to borrow money.
They will charge higher interest rates than the Fed when they set the interest rates for the various loans they offer after taking various other factors into account.
What Happens When Interest Rates Rise?
As you can imagine, the interest rates that banks set affect everything. When a company like Caterpillar wants to open a new manufacturing plant, for instance, they usually must take out a loan.
If the interest rates go up and the loan becomes more expensive, this cost must get passed on to customers who buy Caterpillar products.
The companies who buy those products may reconsider the need for a tractor if the cost rises too high too fast. Especially if they also must take out loans at higher interest rates to purchase large orders of tractors.
This same thing happens to consumers when they go to buy a house or a car. If the interest rates for such expensive purchases get too high, fewer people will want to buy them, and this causes demand to go down.
When demand goes down, prices usually fall to meet demand, though the interest rates stay elevated.
How Do Interest Rates Affect Stock Prices?
Shares in publicly traded companies are priced by computers these days, and they take into account several different things.
The prices are mostly about the number of shares outstanding compared to the number of people who want to buy those shares. Demand for stocks (the rise and fall) also involves a bit of calculation as well as intuition.
By that, we mean that investors tend to buy stocks that they think will either increase or pay higher dividends in the future. And will be based on their advisors and independent research.
For the stock’s price to increase or pay out higher dividends, the companies must show consistent growth in revenues and profits.
What is the Fed’s impact on the stock market?
Investors should pay attention to the Fed’s (Federal Reserves) pronouncements since its actions have an impact on financial markets and the economy as a whole. The Fed has considerable economic power, which has an indirect effect on stock market performance.
The role of the Federal Reserve is to help the U.S. economy operate effectively. It is responsible for financial system stability, monetary policy, regulation of financial institutions and activities, and consumer protection.
The Federal Reserve’s policy-making body, the Federal Open Market Committee, determines interest rate decisions by establishing a target for the federal funds rate.
When banks lend to one another, they use this rate. The Federal Open Market Committee minutes are one of the most important documents issued by the Fed.
Throughout the year, the FOMC conducts eight meetings to examine the national monetary policy. While these sessions are private, FOMC meeting minutes are made public and explain what was discussed at the meeting.
Investors who pay attention to these announcements may get a sense of what opportunities to anticipate from the markets in the future.
Rising interest rates affect that last point about growth of revenues and profits quite heavily. After all, we discussed how companies like Caterpillar work with loans all the time.
When interest rates rise, it’s a near certainty that companies will experience a decrease in their bottom-line profits shortly.
This causes stock prices across the board to drop, especially the stocks for companies that may have been propped up by heavy emphasis on possible future growth.