Interest rates–and interest rate fluctuations–are a fact of life for investors. The reality for stock market investors is that even small adjustments to interest rates can have a significant impact on their portfolios.
There are three main ways interest rates can affect the stock market:
• First, higher interest rates raise the cost of borrowing for consumers and corporations, which can ultimately affect the earnings of public companies.
• Second, the stock market is efficient. That means it’s prone to pricing in information immediately, even if the actual repercussions from an interest-rate change won’t be felt for some time.
• Lastly, higher interest rates boost bond yields, making the bond market a more attractive place for investors to park money. This could, in turn, make stocks less attractive by comparison.
Below is a deeper dive into all these effects. For context, interest rates have been at historic lows in recent years, as the Federal Reserve has sought to prop up a sluggish economy. But there’s no guarantee that scenario will last. In fact, rates have started rising moderately in 2021 and some say they may head higher. Here’s how that could affect stocks.
Interest Rates 101
Who controls interest rates? The short answer is the Federal Reserve, or the U.S. central bank. The Fed has a “dual mandate”:
• Create the best environment for maximum employment.
• Stabilize price increases, or inflation.
One of the tools the Fed has in its toolkit to try to achieve these twin goals is controlling short-term interest rates. The Federal Open Market Committee–made up of 12 Fed officials–meet eight times a year to set the fed funds rate, or the target interest rate.
The fed funds rate is the rate banks charge each other to lend funds overnight. Other factors that influence interest rates are demand for Treasuries, U.S. government bonds, as well as demand for mortgages and loans among consumers. But when the fed funds rate goes up for banks, this has sweeping ripple effects on the economy as a whole, by raising the cost of borrowing broadly.
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How the Fed Reacts to Slow Economy
When growth in the U.S. economy is slow–or even contracting, the Fed may cut interest rates. This makes it easier for consumers, businesses, and other economic participants to borrow money and get easier access to credit.
When credit is flowing, Americans are more likely to spend money, more jobs are created, and more money enters the nation’s 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 make credit easier to get and restore confidence among consumers and businesses that the economy would stabilize – and it did.
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 inflation, and hopefully gets the economy back on an even keel.
For instance, from 2015 to 2018, the Fed hiked interest rates nine times to slow a fast-growing U.S. economy, bringing inflation under control and cooling aggressive credit and lending.
Going back further in history, one famous example of this is when Fed Chair Paul Volcker jacked up interest rates during the 1980s in order to tame runaway inflation. For context, the 30-year mortgage rate then went above 18%. Compare that to the sub-3% rates people enjoyed in 2020.
Recommended: A History of the Federal Reserve
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, as higher rates make it more expensive for consumers to borrow money with credit cards, for mortgages, personal or small-business loans.
When consumers have a tighter grip on their pocketbooks, that may negatively affect companies, who find it more difficult 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 bank 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, in a lower interest rate environment, companies can borrow money more freely, which puts them in a better position to raise capital, improve company profitability, and attract more interest in the company’s stock.
Interest Rates and Markets
According to a study from Fidelity Investments , when the discount rate (i.e., the rate at which investors pay today for expected cash inflows in the future) rises by just 1%, the benchmark S&P 500 Index would fall by an estimated fair value of 800 points. That’s about a 20% decline based on the S&P 500’s value as of April 1, 2021.
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When it comes to stock market sectors or industries, the most obvious beneficiary of higher interest rates would be financials. That’s because higher interest rates would mean banks and other loan providers would earn more for the money that they lend out.
However, it’s also possible for consumer discretionary companies to be doing well during a period of rising interest rates. That’s because higher rates are usually a sign of a robust economy, which means individuals have discretionary income to go on vacation and buy bigger ticket items.
The key may be to have what’s often called a “Goldilocks economy” or one that’s not too hot that inflation and borrowing costs rise quickly, while one that’s also not too cold that growth is actually slow.
Bonds yields tend to rise when interest rates head higher. That, in turn, attracts yield-seeking investors and hurts the appeal of stocks, particularly ones that pay high dividends–another form of income.
Recommended: Bonds vs. Stocks
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 are on the march.
1. Monitor the Federal Reserve and its rates policy. The FOMC meets eight times a year to discuss economic policy strategy. Announcements from the meetings, even if they don’t result in an interest-rate change, can have a significant impact on the stock market. Click here for the 2021 FOMC schedule .
2. Diversify Your Portfolio. Investors can aim to protect their assets by diversifying their portfolio up front. By holding a mix of investments like stocks, bonds, real estate commodities and cash, for example, a portfolio can have a broad range of assets categories that are more or less equally sensitive to interest rate moves, thus minimizing the impact of any volatile interest rate fluctuations.
3. Look Into TIPS. An investment in Treasury Inflation Protected Securities (TIPS) can fortify your 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. Exchange-traded funds or ETFs based on TIPs can also be an option.
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Ultra-low interest rates since the 2008 financial crisis have fueled a rocketship-like rally in stocks over the past decade in the U.S.
In 2021, Fed Chair Jerome Powell has said that the conditions to raise interest rates–full employment and moderate inflation–are still far from getting achieved. However, expectations for robust economics growth in the Treasury market and among consumers have already pushed rates higher.
Changes in interest rates have far-reaching effects on share prices. In general, higher interest rates tend to have a dampening effect on stocks, while lower interest rates tend to boost market prices. The impact on the market typically occurs in three ways:
1. The stock market prices in changes to economic conditions preemptively. Hence, investors see an immediate reaction in share prices after an FOMC decision.
2. Second, higher interest rates effectively means higher borrowing costs, meaning any loan consumers or business have on their balance sheets will cost them more.
3. Third, higher interest rates can boost the appeal of bonds relative to equities.
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