The impact of interest rates and their fluctuations are a fact of life for investors. And there are several ways interest rates can affect the stock market, like how higher interest rates raise the cost of borrowing for consumers and corporations, which can ultimately affect public companies’ earnings. The reality for stock market investors is that even minor adjustments to interest rates can significantly impact their portfolios.
Below is a deeper dive into the effects interest rates may have on stock prices. For context, interest rates are rising to levels the economy hasn’t experienced in decades, thanks in part to the Federal Reserve’s attempts to fight rising prices. Here’s how that could affect stocks.
Interest Rates 101
Who controls interest rates? While many market factors come into play to determine interest rates, the short answer is that the Federal Reserve, or the U.S. central bank, influences rates.
The Fed has a “dual mandate”:
• Create the best environment for maximum employment.
• Stabilize prices, or keep inflation in check
One of the tools the Fed has in its toolkit to try to achieve these twin goals is controlling short-term interest rates. This is done by the Federal Open Market Committee (FOMC)–made up of 12 Fed officials–which meets eight times a year to set the federal funds rate, or the target interest rate.
The federal funds rate is the rate banks charge each other to lend funds overnight.
Other factors influence general interest rates, like consumers’ demand for Treasuries, mortgages, and other loans. But when the Fed adjusts the federal funds rate, it has sweeping ripple effects on the economy by broadly changing the cost of borrowing.
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How the Fed Reacts to Slow Economy
When economic activity in the U.S. is slow or contracting, the Fed may cut the federal funds rate to boost growth. This move, known as loose monetary policy, is one way the Fed attempts to hit the mandate of creating the best environment for maximum employment.
Lower interest rates make it easier for consumers, businesses, and other economic participants to borrow money and get easier access to credit. When credit flows, Americans are more likely to spend money, create more jobs, and more money enters the financial markets.
Recent history bears this strategy out. In 2008, when the global economy cratered, and both employment and spending were in free fall, the Fed slashed rates to near zero percent to make credit easier to get and restore confidence among consumers and businesses that the economy would stabilize. The Fed again cut interest rates in March 2020 to near zero percent to stimulate the economy during the initial waves of shutdowns due to the coronavirus pandemic.
How the Fed Reacts to Hot Economy
Alternatively, if the U.S. economy is growing too fast, the Fed might hike interest rates to get a grip on rising inflation, which makes goods and services more expensive. This is to make borrowing and getting credit more expensive, which curbs consumer and business spending, reduces widespread prices, and hopefully gets the economy back on an even keel.
For instance, in the early 1980s, Fed Chair Paul Volcker jacked up interest rates to above 20% in order to tame runaway inflation; prices were rising by more than 10% annually during the period. Volcker’s interest rate moves were a big reason why the average 30-year mortgage rate was above 18% in 1981.
More recently, the Fed started to raise interest rates rapidly through 2022 to combat rising prices, with inflation rates hitting the highest levels since the early 1980s.
Interest Rates and Markets
Most analysts note that interest rate changes, or the expectation of rate changes, can significantly affect the stock market beyond how rates may impact business and household finances.
Generally, higher interest rates tend to be a headwind for stocks, partly because investors will prefer to invest in lower-risk assets like bonds that may offer an attractive yield in a high-interest rate environment.
But lower rates may make the stock market more attractive to investors looking to maximize growth. Because investors cannot get an attractive yield from lower-risk bonds in a low rate environment, they will put money into higher-risk assets like growth stocks to get an ideal return.
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When it comes to stock market sectors or industries, the most obvious beneficiary of higher interest rates would be financial services companies. That’s because higher interest rates would mean banks and other loan providers would earn more for the money that they lend out.
Protecting Your Investments From Higher Rates
Fortunately, there are strategies you can use to protect your portfolio – and possibly – add value to it, when interest rates change.
• Monitor the Federal Reserve and its rates policy. The FOMC meets eight times a year to discuss economic policy strategy. Even if they don’t result in an interest rate change, announcements from the meetings can significantly impact the stock market.
• Diversify your portfolio. Investors can aim to protect their assets by diversifying their portfolio up front. A portfolio with a mix of investments like stocks, bonds, real estate, commodities, and cash, for example, may be less sensitive to interest rate moves, thus minimizing the impact of any volatile interest rate fluctuations.
• Look into TIPS. Investing in Treasury Inflation Protected Securities (TIPS) can fortify a portfolio against interest rate swings. TIPS are a form of Treasury bonds that are indexed to inflation. As inflation rises, TIPS tend to rise. When deflation is in play, TIPS are more likely to decrease.
How Interest Rates Affect Consumers
In a period of high interest rates, publicly-traded companies face a potential indirect threat to revenues, which could hurt stock prices.
That’s due to the reduced levels of disposable income in a high-rate environment. Higher rates make it more expensive for consumers to borrow money with credit cards, mortgages, or personal or small-business loans.
Consumers’ tighter grip on their pocketbooks may negatively affect companies, who find it more challenging to sell their products and services. With lower revenues, companies can’t reinvest in the company and may experience reduced earnings.
How Interest Rates Impact Companies
Businesses that are publicly traded can experience significant volatility depending on interest rate fluctuations. For instance, changes in interest rates can impact companies through bank loan availability.
When rates rise, companies may find it more difficult to borrow money, as higher interest rates make bank loans more expensive. As companies require capital to keep the lights on and products rolling, higher rates may slow capital borrowing, which can negatively impact productivity, cut revenues, and curb stock growth.
Correspondingly, companies can borrow money more freely in a lower interest rate environment, which puts them in a better position to raise capital, improve company profitability, and attract investors to buy their stock.
Changes in interest rates can have far-reaching effects on the stock market. In general, higher interest rates tend to have a dampening impact on stocks, while lower interest rates tend to boost market prices. Higher interest rates effectively mean higher borrowing costs that can slow down the economy and companies’ balance sheets and drag down stock prices. Additionally, higher interest rates can boost the appeal of bonds relative to equities, which also acts as a drag on stocks.
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