Why Do Interest Rates Affect the Stock Market?

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Yesterday, Wall Street closed out the month in style, with all three major indices finishing in the green for the second month running. Specifically, the Dow Jones, S&P 500 and Nasdaq composite closed yesterday’s session with daily gains of 2.18%, 3.09% and 4.41% respectively.

Wednesday’s rise on Wall Street was triggered by comments made by the chairman of the Fed Jerome Powell during a speech at the Brookings Institute think tank in Washington, regarding the outlook for the US economy.

Investors were listening closely for any hint of the Federal Reserve’s next moves ahead of its policy meeting in a few weeks. They were not disappointed.

Powell announced that “it makes sense to moderate the pace of our rate increases as we approach the level of moderation that will be sufficient to lower inflation,” before adding, “The time to moderate the pace of rate increases may come soon. like the December meeting .”

While these comments were largely in line with previous remarks from the Fed in recent weeks, investors cheered the dovish tone. The response on Wall Street was almost immediate, as all three major US indices began to soar shortly after Powell took the stage.

But why are investors so bothered about interest rate? How and why do they affect the stock market?

Inflation, Interest Rates and the Stock Market

Interest rates are the most important tool a central bank possesses in the fight against inflation. When inflation is high, as is currently the case, central banks normally raise rates in an attempt to bring inflation back down to their target rate of around 2%.

Higher interest rates essentially reduce consumption and investment, which, in turn, puts downward pressure on prices. Higher interest rates work to combat rising prices in several ways:

  • They increase the cost of borrowing, which discourages new borrowers from buying large portfolio items, such as a house or car.
  • Higher interest rates also increase the cost of servicing existing debt, which reduces consumers’ discretionary income. Less discretionary income = less spending, especially on non-essential items.
  • Consumers earn more interest in saving deposits with the bank, which encourages them to save money rather than spend or invest it.

As we described above and witnessed countless times this year, changes in interest rates also have an impact on the stock market.

Generally, the two have an inverse relationship. When interest rates rise, the stock market tends to move in the opposite direction, and vice versa. But what is the logic behind this?

Rate Increases and Stock Prices

Above we emphasized how higher interest rates reduce consumption and, consequently, lower prices. We looked at this strictly from a consumer’s perspective, but interest rates affect everyone, including businesses.

A rise in interest rates – and, consequently, a rise in the cost of borrowing – will affect businesses in a number of ways:

  • Increased operating costs
  • Less capital for investment in future growth
  • Fall in sales due to lower discretionary income and reduced incentive for borrowing

Let’s look at these one by one.

Increased Operating Costs

The vast majority of businesses will have some level of debt on their books. Rising rates will increase the cost of servicing this debt, increasing operating costs and, subsequently, reducing the company’s profitability.

Less Investment in Future Growth

Falling profits mean less money to invest back into the company for future growth. In addition, due to the increased cost of borrowing, the firm may be less inclined to increase its credit for investment purposes.

Drop in Sales

Rising interest rates mean that consumers have less money to spend, so they consume less. Who bears the consequences of this? Businesses.

Less consumption naturally translates to lower sales, which leads to lower revenues and, subsequently, lower profits. This reinforces the effect described above. As well as increased operating costs weighing on profits, so are falling sales, and even less capital is available for investment in future growth.

So what?

Lower profit and less investment in future growth reduce a company’s estimated future cash flow. All else being equal, this makes the company less attractive as an investment. Existing shareholders may be persuaded to sell their stake, and prospective investors may seek another destination for their capital, causing share prices to fall.

Of course, everything described takes some time to filter after interest rate. However, the stock market does not wait for these consequences to actually occur, it anticipates them and adjusts itself accordingly.

Therefore, any sign that there will be a change in interest rates will usually cause a reaction in the stock market as investors try to price in the anticipated outcome. Thus, yesterday, we saw a very positive reaction on Wall Street, as investors digested Powell’s comments about interest rate hikes.

While rates will likely continue to rise, the fact that these increases will be more moderate than previous increases was enough to improve sentiment among investors.

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This material does not contain and should not be considered as containing investment advice, investment recommendations, an offer or solicitation for any transactions in financial instruments. Please note that such business analysis is not a reliable indicator of any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks involved.

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