Interest Rates Have a Major Impact on Stock Market Behaviour. The cost of borrowing money for companies & consumers will impact investors’ valuation of the stock market. If the interest rate rises, the cost of borrowing increases for both consumers & companies. The increase of borrowing costs can decrease the growth of companies, reduce profitability & make stocks less attractive. If interest rates are falling or remain constant, it allows more opportunity for companies to invest and increases investors’ confidence in being shareholders of companies.
The Federal Reserve’s Role
The Federal Reserve is responsible for managing short-term interest rates in America. Changes to interest rates made by the Fed influence many aspects of the entire economy, including loan rates, mortgage rates, and corporate financing. Furthermore, the Fed’s action to increase or reduce interest rates has an effect on long-term bond yields. Investors utilise long-term bond yields as a way to evaluate their expected future company earnings in 10 years in today’s terms. Even though interest rates are at levels greater than during the last ten years, the stock markets have continued to show strength, coupled with interest rates decreasing and corporations continuing to show good earnings growth.
How Rates Affect Stock Valuations
Generally, stable or lower interest rates support the prices of stock, as they allow companies to refinance debt and expand operations or to see how things will play out in the future. At the same time, investors tend to pay higher prices for stocks when interest rates are lower because they believe the company will earn a greater amount of money in the future. Therefore, the lower or more stable an investor can get in terms of interest rates, the more likely he/she is to purchase that stock at a higher price.
What Bond Yields Signal to Investors
Yields on long-term bonds show us a lot about both inflation and economic growth. When yields fall due to lower expected levels of inflation while still showing stable levels of economic growth, there is often a positive response in the equity market. In contrast, when yields increase due to concerns over inflation or government bond debt, investors normally take a more cautious approach with their investment strategy, typically demanding stronger levels of corporate earnings.
Interest Rates and Market Sectors
Stock market sectors and industries will have a different response to changes in interest rates. Certain sectors will benefit from a drop in interest rates, while others require a strong demand for goods/services or a certain level of growth driver to benefit from falling rates. The recent trend among investors has been to pay closer attention to companies’ performances and earnings than to interest rates themselves.
Looking Ahead
Increasing interest rates will continue to have an impact on the stock market, but there are also a number of other factors that influence the stock market – such as corporate earnings, economic growth and long-term planning. Therefore, long-term investors that concentrate on long-term goals typically achieve better results than those that constantly adjust their investments based upon interest rate changes.