How do interest rates affect the stock market
Interest rates are one of the key factors that drive macroeconomic environment and market sentiment. When a central bank increases or cuts rates, there can be a profound effect on the country’s stocks, with some winners and losers along the way.
What’s the mechanics behind this relationship, and how do interest rates affect stocks?
How do interest rates affect the stock market?
High interest rates often tend to negatively affect earnings and stock prices. When high inflation forces central banks to raise interest rates, companies face a higher cost for borrowing and higher payments on current debt.
Yet different types of stocks tend to show various behaviours in a high-rate environment. For example, growth stocks and cyclical stocks would underperform, with value and cyclicals likely to trend relatively higher.
Growth stocks
Growth stocks are rapidly expanding companies that are expected to grow and outperform the market. These stocks show potential of earning profit faster, and are often juxtaposed with value stocks.
Growth stocks often take out loans that they are confident in paying back, because the expectation is that interest rates will be stable. As these firms tend to be in the early stages of development, borrowing money is crucial, and they tend to have longer-term cash flow horizons, hence affected more negatively by higher interest rates.
Daniela Hathorn, Capital.com’s market analyst explained:
Value stocks
When central banks raise rates, value stocks often tend to outperform the market and do better than growth stocks. This is because they are generally less volatile.
Value stocks tend to be more well-established companies, which pay stable and regular dividends. Hence value stocks enjoy more demand, even when people spend less.
Daniela explains:
The analyst added that some value stocks are often perceived as the basics of a balanced portfolio, hence the effect of interest rate changes will be less significant.
Cyclical stocks
As cyclical stocks are more affected by macroeconomic changes in the overall economy, they are more negatively impacted by interest rate hikes versus non-cyclical stocks.
When rates fall, the economy tends to be stimulated. This means people have more spending power and consumers buy more, which helps cyclical stocks. Often they are restaurants, hotel chains or retail businesses that thrive during consumer spending boosts.
On the contrary, when rates rise, cyclical stocks are affected negatively, as consumers have less spending power. As a result cyclical stocks may suffer a bearish trend, according to Daniela:
Bank stocks are an interesting example, as they are cyclical yet can also benefit from high interest rates boosting their lending margins. But the rise in interest rates typically follows inflation or precedes recessions, hence there is an expectation of loan defaults that can counteract higher lending revenues.
Defensive stocks
Also known as non-cyclical stocks, defensive stocks tend to be more stable, regardless of the current state of the economy, as a result they are less affected by interest rate rises and recessions.
These tend to be utility companies and firms whose products consumers cannot cut off when the money is tight, for example, medicines. Hence when rates rise defensive stocks are less affected, as the demand for their products and services is still there.
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How changes in interest rates affect bond yields and investor sentiment
Bond prices tend to be inversely correlated with interest rates. Bond yield, on the other hand, is the amount an investor makes off a bond investment, rises when interest rates are hiked, and vice versa.
As Capital.com’s Daniela explained, during high-interest rate periods, bonds become more attractive because they offer a higher yield:
Coming out of the 2008 financial crisis, the US Federal Reserve (Fed) has gradually been increasing rates. From the chart below, we can see the Fed Funds Rate has moved up from 2015 to 2017. We can also see bond yields rise in accordance.
Investor sentiment tends to shift with monetary policy, too. An interest rate cutting cycle typically creates a risk-on environment and prompts more liquidity into the markets as investors seek out higher returning assets.
Yet when interest rates rise, investors may become more risk-averse and seek the safety of bonds as yields become more competitive.
Relationship between interest rates and stock prices
Historical observation has shown that stock prices and interest rates have an inverse relationship, meaning as interest rates rise, stock prices tend to move lower.
In the below chart, since 1987, you can see that as the Fed Fund rate started to fall, the S&P 500 Index (US500) trended higher.
However, research conducted by the University of Glasgow, which looks at the stock market’s reaction to Fed’s rate hikes since the onset of the credit crunch and up until early 2009, showed stock market investors have faced falling stock prices, together with cuts in interest rates, indicating that the impact of interest rates on the stock market may have weakened.
The research found that prior to the 2008 financial crisis, stock prices increased as interest rates fell. Pre-crisis period, stock prices displayed larger increases, when interest rates were eased. However, during the crisis, the stock market did not react positively to rates being lowered. The data indicated that there was a statistically significant negative stock market response to the large Fed rate cuts that took place throughout the financial crisis.
Key factors that affect interest rates and the stock market
There are various factors that affect interest rates and the stock market, yet arguably the key might be inflation and economic growth. Policymakers would typically look at the two indicators in their interest rates decisions.
Inflation: Rising inflation leads to higher interest rates. As prices rise due to inflation, corporations profit and growth margins are affected, thus leading to lower investor confidence, which affects their willingness to take on risk by holding onto stocks.
Economic growth: Negative economic growth could hurt investor sentiment and prompt a risk-off shift. Recessionary fears may also prompt central banks to stimulate the economy by rate cuts and quantitative easing (QE), provided inflation is moderate.
Conclusion
Interest rates are a charge on borrowing money, but also a credit for saving money. High inflation leads central banks to raise the interest rates, and this has a domino effect on companies. High interest rates tend to negatively affect corporate earnings and hence stock prices.
However, different types of stocks tend to perform differently when interest rates rise. For example, growth stocks and cyclical stocks would underperform value and defensive stocks.
Interest rate rises and cuts can also shift investor sentiment between risk-off and risk-on, as well as affecting bond yields. Higher interest rates tend to make bonds more attractive.
Historical observation has shown that stock prices and interest rates have an inverse correlation between interest rates and stock market, meaning as rates rise, share prices tend to move lower. However, data has also shown that during the 2008 crisis, the stock market did not react positively to rate cuts, implying that the relationship may be weakening.
There are various factors that affect interest rates and the stock market, with the key being inflation and economic growth.
FAQs
How do rising interest rates affect the stock market?
High interest rates tend to negatively affect corporate earnings and stock prices, yet different types of stocks tend to perform differently when interest rates rise. For example, growth stocks and cyclical stocks might underperform value and defensive stocks.
What happens to the stock market when interest rates go down?
When interest rates go down, stock market prices have tended to increase. However, data has also shown that during the 2008 crisis, the stock market did not react positively to rate cuts, implying that the inverse relationship may be weakening.
How do interest rates affect bond yields ?
Bond yield, which is the amount an investor makes off a bond investment, tends to rise when interest rates are hiked, and vice versa. Hence during high-interest rate periods, bonds may become more attractive for investors.
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