In recent weeks, the news has been filled with talks about the prospect of interest rate rises in the year. While it may take a longer time for the rest of the economy to feel the effects of a change in the interest rates, the stock market generally experiences an immediate impact. Therefore, understanding how interest rates impact stock markets is crucial for investors to know how it may affect their investments.
First, it is important to establish whether there is any correlation between interest rates and stock markets. The daily interest rates that we encounter all follow cues from the set base rate. This is the interest that a central bank pays institutions that store money with them such as other banks. They also charge the same rate of interest when these institutions borrow money from them. It is a nation’s central bank that sets the base rate. In the UK, this is a role played by the Bank of England.
When interest rates are high, people and businesses are discouraged from spending and investing since the cost of borrowing increases. There is also an incentive to just let the money stay in ban since it will earn higher interest. The decrease in spending lowers prices for commodities and slows economic growth. When the interest rates are low, the opposite is true because people and businesses have an incentive to spend and invest more. The question, therefore, becomes how exactly do interest rates affect the stock market?
Impact of high-interest rates on stock markets
Typically, when the interest rates increase, the stock market falls. This is because rising interest rates signal uncertainty in the economy. In turn, businesses and people become reluctant to invest and encourage risk-averse behavior. This impacts growth thereby making share prices suffer.
When the bank of England raises interest rates, it increases the cost of borrowing for both people and businesses. This comes with its own consequences such as increased operating costs of businesses. The cost of serving debts becomes expensive and since almost all businesses have some debt, their profitability is reduced.
Investing in future growth becomes challenging for businesses since they are less profitable. They also lack the incentive to borrow to invest in future growth to avoid more debt. When businesses are not able to invest in future growth, their profits are significantly reduced resulting in share prices falling.
The increased cost of borrowing also discourages consumers from borrowing to make huge purchases. The existing debt that they may have also become expensive to service making consumers have less disposable income. This affects the sales made by businesses and companies which in turn affects their profitability further.
Impact of low-interest rates on stock markets
Predictably, lower interest rates affect the stock market in the opposite way to higher interest rates. Lower interest rates will mean a decrease in the cost of borrowing which will have the opposite effects as discussed above.
Business operating costs will be lower. This is because the cost of borrowing will reduce as well as the cost of servicing existing debts. In turn, their profitability increases making it easier to invest more in future growth. In addition, since the cost of borrowing will be negligible, both people and businesses will find it easier to borrow and invest in the stock market.
With increased profitability, the estimated future cash flow for companies and businesses also increases and results in share prices performing well. This makes the companies more attractive to both existing and prospective investors.
Lower interest rates also affect consumer behavior positively. The consumer will have more discretionary income at their disposal which will lead to an increase in consumption. Increased consumption translates to more profitability which leads to more investment in future growth.
In conclusion, interest rates and stock markets are intertwined. A change or increase in interest rates has almost immediate impacts on the stock markets. Investors need to be well informed of how the two affect each other to make wiser investments and profit more.
