Changes in interest rates not only affect the economy but they also impact stock prices. Learn how falling and rising interest rates affect the stock market.
Interest Rates & Premiums Paid For Risky Assets
Investors who buy and hold stocks expect to receive higher returns in exchange for taking on greater risk, as compared to a risk-free asset, such as a U.S. Treasury bill, or T-bill. This excess return above the risk-free rate is called the risk premium, which can be impacted by the direction of interest rates.
For example, when interest rates rise so do yields rise on newly issued Treasury bills. The more investors get paid for holding a risk-free asset, the lower the risk premium on a risky asset, such as a growth stock. In simple terms, when a risk-free asset begins looking more attractive, a risky asset look less attractive in comparison.
When interest rates fall, investors see the opposite scenario, where yields on T-bills fall and the risk premium on risky assets increases. Thus, risky assets such as growth stocks appear more attractive and their prices rise.
Note: The risk premium is the return an asset is expected to produce in excess of the risk-free rate of return, which is the return expected from an investment with low chance of financial loss. A traditional benchmark for the risk-free asset is the Treasury bill, or T-bill, because it's backed by the U.S. government.
What Is The Federal Funds Rate?
The federal funds rate is an interest rate set by the Federal Open Market Committee, or FOMC, policy-making committee of the Federal Reserve System. Commercial banks use the FOMC's target rate for borrowing or lending cash overnight to meet the Fed's reserve requirements.
Note: Effective March 26, 2020, the Federal Reserve reduced its reserve requirement to zero. This policy will remain in effect until the Fed decides to increase its requirement. However, the Fed still incentivizes banks to maintain cash in reserves by paying "interest on reserve balances," or IORB." pays interest on money the banks keep in reserve.
How Does The Federal Reserve Raise Interest Rates?
The Federal Reserve raises interest rates by increasing its Federal Funds Rate, which is the target reserve rate that banks use for overnight loans The Fed also raises rates by selling bonds in the open market. Both of these actions reduce the money supply for the purpose of slowing the economy, which may reduce inflation.
How Does The Federal Reserve Lower Interest Rates?
The Federal Reserve lowers interest rates by decreasing its Federal Funds Rate, which is the reserve interest rate that banks use for overnight loans. The Fed may also lower interest rates by purchasing bonds in the open market. Both of these actions increase the money supply for the purpose of stimulating economic growth.
Interest Rates & Inflation
There is an inverse relationship between interest rates and inflation. For example, if the Federal Reserve raises its Federal Funds Rate, it is "tightening" the money supply, which helps to control inflation. And when the Fed is "loosening" or "easing" the money supply through lowering rates, inflation tends to rise.
How Rising Interest Rates Impact Bond Prices
There is an inverse relationship between interest rates and bond prices. For example, when interest rates are rising, the yields on bonds are generally rising. Since the lower yields on current bonds become less attractive in a rising rate environment, the market prices for those bonds tend to fall.
Tip: The longer the duration on a bond, the more sensitive it is to interest rates. For example, when interest rates are rising, the prices for long-term bonds, or those with durations over 10 years, tend to fall more than those with shorter durations. The opposite is also true. When interest rates are falling, long-term bond prices are expected to rise faster than those with shorter durations.
How Rising Interest Rates Impact Stock Prices
When interest rates rise, it costs more money for commercial banks to borrow money and these banks tend to pass along these rate increases to their customers, which may be individual consumers, small businesses or larger corporations. This higher cost of money tends to impact prices of capital assets such as stocks and bonds negatively.
The fundamental reason that rising rates can be bad for stock prices is that higher borrowing rates tend to shrink profit margins for corporations. Since their customers are also faced with higher borrowing costs, the demand for goods and services is often reduced, which further erodes the profitability of corporations.
How Falling Interest Rates Impact Bond Prices
Since there is an inverse relationship between interest rates and bond prices, declining rates will push bond prices higher. The reason for this is that lower rates pay less interest, which makes bonds that pay higher interest more attractive, pushing market prices higher.
How Falling Interest Rates Impact Stock Prices
When interest rates fall, the borrowing costs for banks, businesses and consumers are fall. Lower borrowing costs not only tends to increase profit margins for businesses, the increase in money supply in the economy also tends to create higher demand for goods and services. The combination of higher profit margins and greater consumer demand is generally positive for stock prices.
Interest rates impact the stock market and the broader economy. Changes in interest rates may affect stock prices immediately, whereas the effect on the economy may take several months. Falling rates stimulate the economy by decreasing the cost of borrowing, whereas rising rates aim to slow the economy and control inflation by increasing the cost of borrowing.
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