The Inverse Relationship of the Stock Market and Interest Rates

The interest rates will rise this year and that means borrowing money becomes more expensive. While consumers and businesses are not waiting for this, the Federal Reserve argues that higher interest rates are necessary to bring down the inflation levels that are reaching new heights every month. As interest rates affect our everyday lives and the stock market, it is important to understand the effects and the correlation with the stock market to be able to make better investment decisions.

What are Interest Rates?

The interest rate is the cost of making money available and it is the money paid overtime to borrow a sum of money. It serves as compensation for the risk that the borrowed money can’t be fully paid back.

An example is when you deposit money in your savings account. The bank can use this money to lend to other parties but there is (albeit small) risk the bank can’t fully pay your money back. Therefore you receive compensation in the form of a savings rate for making that money available to the bank. The bank in its turn receives interest for their financing activities that are used, among others, to grant the savings rate.

Market Dynamics of Supply and Demand

Normally interest rates vary along with the status of the economy. Saving money becomes more attractive if interest rates increase, as you’ll receive more money for just leaving it on your savings account. This decreases consumption. Borrowing money also becomes more expensive which will lead to fewer investments and a decrease in the demand for money in the market, thus pressing interest rates downward.

In a low-interest-rate environment, money is cheaper so it’s more enticing to spend money in the form of consumption and investments. This effectuates an increase in demand for money in the market which causes interest rates to climb higher.

The dynamics of supply and demand constantly looking for a market equilibrium should keep interest rates in balance, but in practice, occasional interventions of the central bank or government are necessary to fend off undesirable extremities.

Manually amending interest rates

Interest rates are used to regulate the supply and demand of money for consumption, investments, and the employment rate. Monetary policy, government instructions, short-term political gain, and inflation are the primary reasons to alter interest rates.

Monetary Policy
The Federal Reserve and other central banks carry out a monetary policy where the main objectives are fostering economic conditions for stable prices, maximum employment, and moderate long-term interest rates. To achieve these objectives, the Fed can target the federal fund rate, which is the rate that depository institutions such as banks and credit institutions charge each other for overnight loans. The federal fund rate also forms the basis for the interest rates banks charge their customers for a mortgage, business and consumer loans.

To create and sustain economic conditions that benefit the objectives of the Fed, it needs to constantly monitor factors such as consumption, prices of goods and services, inflation, the unemployment rate, investments, and interest rates. Although the Fed is an independent institution, it usually considers governmental directions to a certain extent for their decisions.

Government
The government gives directions to the central bank to accomplish its economic goals. The central bank can increase interest rates to keep inflation levels in control and it generally reduces the interest rate to increase consumption and investments and the employment level in the economy.

However, maintaining a low-interest rate over a longer period can be risky as this shapes an environment where large amounts of money are poured into the stock market, which has the potential to fuel an economic bubble.

The government can also choose to buy more securities which is a move that injects money into the economy and has a pressing effect on interest rates. Nevertheless, the government needs to beware of possible inflationary effects of higher consumption and investments.

Political short term gain
The government benefits from creating a climate that encourages consumerism to create more jobs and gives the economy a boost. Therefore, lowering interest rates is a move that has been used around the world to get more votes leading up to re-elections. Although the increase in economic activity has a positive effect, under normal conditions, a significant cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. Consequently, most economists plead with independent central banks to limit the influence of politics on interest rates.

Inflation

Prices increase if demand for goods and services is higher than its supply, and an increase in prices is expressed as the inflation rate. Countries usually target inflation around 2%, considering a slightly higher demand for than supply of goods and services stimulates economic growth. An inflation rate much higher than that usually means prices increase more rapidly than wages, which decreases the purchasing power of consumers that slows down the economy.

The most notorious factor lately is the annual inflation rate around the world. In the US that number accelerated to 7.9% in February 2022, which is the highest increase since 1982. The biggest contributors to this level of inflation are the increases in energy costs such as gas, food, labour shortages, and supply chain bottlenecks.

Recent geopolitical tensions and military activities of Russia in Ukraine are also influencing inflation. Prices of goods such as oil, gas, wheat and grains have already increased double digits and intense military activities tend to further increase inflation. The full effects of these developments haven’t been calculated in the inflation rate yet, but the Fed wants to step in and has announced to increase interest rates to counter the high inflation developments.

The Relationship with the Stock Market

Modifying interest rates impacts both the economy as well as the stock market as lower interest rates generally increase consumption and investments, and higher interest rates decrease economic activity. To regulate economic activities, the government wants to control interest rates to keep inflation within a target range

The Fed can manage interest rates as a monetary tool in three manners. In case economic growth is slowing down, they can reduce the interest rates to stimulate economic activity to give the economy a boost. This normally increases the future earnings potential of businesses and may in turn translate to higher stock prices.

Next to lowering interest rates or leaving the rates up to market dynamics, the Fed can also increase interest rates if the market is getting too hot. Typically, this move is reserved for strong markets or if inflation is getting out of hand.

The majority of businesses and consumers have some level of debt. Higher interest rates mean higher expenses for business and consumer loans, mortgages and credit cards which means lower profit for businesses. This is especially the case for growth companies and some technology companies that depend heavily on debt for their investments.

Consumers with less discretionary spending will buy fewer products and services, which in turn leads to a further reduction of the revenues and profits of businesses and that translates to lower stock valuations. However, some sectors benefit from higher interest rates such as the financial industries, as they can charge more for lending activities. Other businesses such as in the consumer goods sector can fend off higher interest rates and inflation as they can calculate higher costs for their products to keep the profit margins up.

The Fed can also leave interest rates up to the market dynamics of supply and demand. The market will find a new equilibrium but in the process, the demand for money could drop continuously and lead to more and more unemployment. And as unemployment is bad for the economy and lives, the Fed usually steps in to reduce the risk of a recession.

Warren Buffet puts the correlation between interest rates and the stock market perfectly in the following metaphor: “interest rates are to the value of assets what gravity is to matter.”

Takeaway

Higher interest rates tend to negatively affect earnings and while it may take some time before its effects impact the actual market, the stock market reacts immediately to a change. And when interest rates make jumps, businesses and consumers will cut back on spending and investors may feel stocks are relatively riskier when interest rates are high and may consider it more attractive to put their money in less risky assets such as government securities, bonds or just leave it on their savings account.

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Financial Moments

Financial Moments

Your 3 minute reads on the economy, personal finance and investing.