How Interest Rates Affect the Market
The financial markets are fickle things that overreact to virtually any new information. Some movements are relatively easy to predict, such as when GDP data comes in higher or lower than expected. Others are more tricky.
The Federal Reserve, an institution designed to maximize employment and control inflation, has become more influential in the markets over the past decade or so, following its quantitative easing program. Investors keep careful watch on what the Fed does and says because it impacts interest rates. And those, in turn, affect almost every corner of the markets, from the value of the United States dollar to stock valuations to bond prices. But it’s not as intuitive as one might think.
The interest rate effect
Interest rates essentially exist for two reasons: the time value of money and inflation. The time value of money says that money now is worth more than money later. If someone loaned out $10,000, they would charge some type of interest rate for it. This makes sense because of the opportunity cost of not applying that money to something that could net a larger return.
Inflation is the bigger threat, though. When inflation is low, interest rates should also be low to encourage growth. Conversely when inflation is high, interest rates should be high in order to curb growth and bring down inflation. Because companies need loans to finance growth and investments, a lower interest rate means higher earnings and less costs due to interest expenses while high interest rates have the opposite effect.
You might think that when the Fed announces an interest rate hike, that it would have a deleterious effect on stocks. After all, higher rates mean more spent on interest and less money for profit and earnings. But in recent years, that hasn’t been the case. In fact, stocks rose in response to the Fed raising interest rates. The reason being that, after years of interest rates near zero, the Fed hiking rates meant a renewed sense of confidence in the economy – something investors felt was more positive than the slight negative of higher rates.
Interest rates always need to be looked at in context. When Herbert Hoover raised rates after the stock market crashed in the late 1920’s/ early 1930’s, he exacerbated the Great Depression. The lesson learned is that rates need to be adjusted only when it makes economic sense. Interestingly, the stock market seems to be able to absorb the impact of higher interest rates over time. At first there might be a drop in values as businesses and investors get used to the higher expense, but eventually the market balances out making overall interest rates irrelevant.