How Do Interest Rates Affect the Stock Market?

How Do Interest Rates Affect the Stock Market?

 

 

When interest rates rise or fall, the financial market reacts visibly. Learn how interest rates affect the stock market and how you can speculate on its short-term direction.

The stock exchange

Bloomberg is the source.

Rates of Interest on Shares The interest rate Stock Exchange

Ntokozo Ngubeni | Johannesburg Financial Writer

What exactly is on this page?

1. What exactly is the ‘interest rate’?

2. What causes central banks to change interest rates?

3. What effect do interest rates have on stocks?

4. The connection between interest, stocks, and bonds

5. How to Take an Interest Rate Position

What exactly is the ‘interest rate’?

The interest rate is a percentage that a lender of capital charges on a borrower’s debt repayment, which is usually paid out over a set period of time. When you take out a loan from a bank, for example, you will be charged interest on the principal amount borrowed.

 

It is also the value that the bank provides individuals for saving their money with them over a set period of time.

In any economy, there are various ‘interest rates,’ and they vary by institution. The most important interest rate, however, is set by central banks and impacts all others.

 

In the United States, for example, there are two rates: the Federal Funds Rate and the Federal Discount Rate. The first is the rate at which banks lend to one another, while the second is the rate at which banks lend to the Federal Reserve (Fed)

 

When these are increased or decreased, the cost of borrowing charged by banks to businesses, households, and consumers rises or falls. This has an impact on how much money people have available to spend in the economy.

 

The US Fed hiked interest rates by 0.25 percentage points in 2022, from 0.5% to 0.75%.

 

1 As a result, changes in the Bank Rate directly affected some of the other interest rates imposed by commercial banks, including the following:

 

The prime rate is the interest rate that banks charge their best customers who have an excellent repayment record.

Credit rate: the interest rate charged to hazardous consumers with fair or poor credit who wish to borrow money.

Mortgage rate: the interest rate charged on a mortgage over a certain term.

Below, we examine how this shift has affected stock market traders and investors.

 

What causes central banks to modify interest rates?

To keep inflation under control, central banks adjust interest rates.

 

When inflation is too high, for example, the central bank hikes interest rates. The increased interest rate causes less expenditure in the economy, slowing the rate of inflation.

 

They cut the rate, on the other hand, to stimulate the economy and encourage spending, so promoting economic activity and growth.

 

The image depicts how an increase in inflation drives the central bank to raise interest rates.

Learn more about inflation hedging.

 

What effect do interest rates have on stocks?

In general, interest rates and stock prices tend to move in opposite directions, ignoring other factors that influence the stock market. Whereas changes in interest rates take months, if not years, to filter through the economy, changes in stock markets are immediate. This is due to the fact that it influences stock investors’ expectations about future stock performance.

 

When the central bank raises interest rates, it will have a knock-on effect on other fees that banks charge their customers. As a result, banks will charge consumers more for credit, reducing their purchasing power.

 

Consumers will take fewer loans as a result of the high credit rate, and with what’s left over, they’ll have to pay more on existing credit. The aggregate disposable income in the country will fall as a result of this ripple effect, and demand for goods and services will slow.

 

Public companies are not immune to the effects of rising interest rates. Borrowing costs for businesses will increase, as will payments on current debt. Because of the revised repayment plan, there will be fewer profits on the books, and the stock price may fall as a result.

 

Image depicting the cycle of how a central bank’s increase in interest rates affects banks, customers, the country’s disposable income, and businesses, causing company stocks to fall.

It’s worth noting that the opposite is also true. This causal loop will not occur for all company stocks; rather, it is a general principle. Different types of stocks will be impacted differently. In high-interest-rate environments, for example, growth stocks typically underperform relative to value stocks.

 

Learn more about the stock market and inflation.

 

When interest rates are high, growth stocks underperform.

Growth stocks are young companies that are expected to outperform the market. When compared to other companies, these stocks have the potential to earn profits faster. For example, technology stocks are frequently predicted to rise and appreciate far quicker than other industries.

 

Despite investors’ predictions that growth stocks will outperform the market, interest rates have frequently acted as a roadblock to that potential being realized.

 

Companies frequently take out loans that they are confident in repaying because they anticipate stable interest rates. Because growth companies are typically in the development stage, borrowing money from a bank is critical to realizing their full potential.

 

When the Fed raises interest rates, it makes it less appealing for investors to back growth equities since they will have less money in the market. Borrowing money from a bank will also be less appealing because payback on existing debt will be increased. When investors are unable to make money, they may prefer to invest in more established, blue-chip value stocks that offer lower returns in exchange for security when interest rates rise.

 

When interest is high, value stocks provide relative security.

Value stocks, on the other hand, are stocks of well-established companies that pay consistent and consistent dividends. Even when people are spending less, many businesses continue to thrive.

 

Furthermore, financial sector stocks such as banks, mortgage lenders, credit providers, insurance providers, and so on may enjoy share price increases as predicted earnings from higher interest rates grow.

 

Value stocks outperform growth companies because they are less risky, which implies lesser returns and dividends are acceptable to investors.

 

The connection between interest, equities, and bonds

The link between interest rates and bonds has an inverse relationship. Bond prices decline when interest rates rise. This is due to the fact that the price of a bond must move in order to remain competitive and appealing to investors when all other rates change.

 

Assume you have a bond worth $1000 that pays a set coupon of $50 per year. That equates to 5% interest.

 

When other interest rates rise above that, say to 5.26%, the bond price must fall to $950 to offer the same interest rate (5.26%) and remain competitive – given that the coupon remains fixed at $50. [$50/ $950 x100 = 5.26%].

 

When interest rates are lower than the coupon rate on a bond, demand for that bond rises since it is a superior investment. As demand grows, so does the bond’s price.

 

On the other hand, if interest rates climb above the bond’s coupon rate, demand will fall, as would the bond’s price.

 

Bonds traditionally carry less risk than stocks and now give larger returns as interest rates rise, making this new risk-reward profile more appealing to investors, who switch from equities to bonds.

 

The inverse is also true. Bond prices rise when interest rates fall. Because bonds are paid in set amounts, the principle of the loan will climb when interest rates fall, allowing only those willing and able to pay the premium to gain exposure.

 

Only a few investors will get exposure to bonds as their prices rise. Because investors would have more money to spend, stock prices will appear more appealing.

 

Find out more about bonds.

 

How to Take an Interest Rate Position

In the short term, leverage derivatives like as CFDs can be used to speculate on the future direction of interest rates. You can go long or short to protect against other investments that may be influenced by interest rate changes, such as mortgage payments.

 

To begin, take these steps:

 

Investigate your selected market.

Create a trading account or practice on a free demo account.

Choose your opportunity

Set your stake size and risk management.

Place your order and keep an eye on your position.

With over 18,000 markets available in IG Group globally, there are various methods to speculate on the effects of interest rate announcements. By opening a CFD trading account, you can have exposure to:

 

Rather of owning actual shares, speculate on share and ETF prices using derivatives.

Trade on the values of the most important sovereign bonds.

Buy or sell stock market index futures or options prices.

Remember that leverage trading increases both your profit and loss because it is computed on the entire amount of the position rather than simply the deposit. That is why you must take precautions to manage your risk.

Trade on inflation with our unique US Inflation Indices.

 

Interest rates and the stock market put together

The interest rate is a percentage that the lender charges the borrower on debt repayment or as a reward for saving money at the bank.

The central bank is in charge of altering interest rates; in the United Kingdom, the Bank of England employs the Bank Rate to counteract growing inflation.

Stocks and interest rates move in opposite ways. When interest rates rise, stock prices fall, and vice versa.

Changes in interest rates influence growth and value stocks differently, with investors preferring value firms when interest rates rise because they provide more security.

You can speculate on the future direction of various worldwide interest rates, as well as trade equities, bonds, and ETFs.

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