Affect of Interest Rates on the Stock Market

COVID-19 has caused increased economic distress, and initially, to combat the pandemic, Federal Reserve brought down the interest rate to 0% – 0.25%. Further, the Fed made bolder moves. However, the Fed’s first tool is often interest rates while attempting to accelerate or decelerate the economy. Irrespective of real estate, stocks in a brokerage account, or bonds in IRA, all the financial assets are affected by Interest rates.

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Despite diverse interest rates for pricing different securities types, most stock traders are generally concerned with central bank action because it can majorly affect equities.

Working of Interest Rates

You might be paying interest on something currently- a student loan, credit card, or mortgage. Whatever be the case, lenders expect you to repay with interest. There is no kindness while lending money, and hence all credit products have interest rates. The higher the rate, the greater you will be reimbursed to the lender throughout the life of debt. Investors primarily follow interest rates as per the Effective Federal Funds Rate (Fed Funds). This “overnight rate” is followed by financial institutions and banks while trading reserves overnight. Reserves are the balance in the federal fund when there is a deposit with the central bank.

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Moreover, the other interest rates, such as banks’ prime rate from creditworthy clients, are influenced by the Fed funds rate. The Federal Reserve’s Open Market Committee (FOMC) meets eight times every year to assess the economy and adjust rates as required. FOMC sets the Fed Funds rate.

In the 1980s, the Fed Funds rate was over 20%, and now, it is about 0%. Moreover, it did not rise around 2.4% since 2009, when the Fed decreased rates due to the financial crisis.

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What is the role of the Federal Reserve, and why does it change the interest rates?

Being a quasi-government institution, the Federal Reserve Bank has excellent control over policy dealing with monetary regulations. Moreover, the elected officials appoint the board members of the Federal Reserve Bank. However, the private lenders make the Fed despite having a “dual mandate” from Congress. As stated in the mandate, the Fed is responsible for two primary factors governing the economy:

Inflation control or Stability in Price

On raising the interest rates, the lenders feel the pressure to reign in borrowing. With increasing costs to borrow money, lenders raise their standards, and the borrowers are less likely to borrow money. If there is no inflation, and the economy is continuously increasing, the raised interest rates drop business investment and consumer spending. In contrast, if the Fed cuts interest rates, they become less expensive and push consumers to spend more. Lower rates urge clients to risk their money. Thus, rate cuts boost the stock market. Cheaper money results in more investment, loans, and banks wanting to lend money to risky borrowers.

How do interest rates affect stock and bonds?

Irrespective of the rise or fall, interest rates affect the equity market. During the rate cut, newly issued debt has to pay lesser than old debt. Therefore, due to decreased yield, investors depend on equities. Lower rates are suitable for the stock market as investors take a risk with cheaper money and hamper bond market returns. Moreover, stocks additionally increase due to increased spending and hiring. On the whole, cheaper money brings more investors and institutions.

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In contrast, bond price increases with increasing rates due to interest rate risk. The government offers debt securities when rates rise, and hence rates increase for publicly-traded firms. Therefore, higher yield increases the demand for bonds. Now, larger returns are possible with the same investment amount. Therefore, to understand long-term trends during trading, you should be aware of the effect of interest rates on stocks and bonds.