I got an email from PinoyInvestor and informed me about the US Federal Reserve’s meeting that will happen this September 17 (September 18 in the Philippines). The meeting is about the decision on whether to start raising interest rates in the U.S. According to PinoyInvestor, stock markets worldwide will surely react, but whether it will trigger a bearish or bullish momentum, will depend on the meeting’s outcome by Friday.
Now, you may want to ask how does interest rates affect the stock market?
I’ll try to explain this topic in a way even a child can understand.
Let’s assume your bank raises its interest rates on fixed deposits from 1% to 10% annual rate. Now, I’ll ask you a question. Would you sell of your equity to invest in bank fixed deposits or hold on to your riskier stock position? Most smart investors would say ‘yes’ because let’s face it, we love to invest into things that gives high returns with little or no risk. If that’s the case, what happens next is that a lot of people will move their money out into the stock market and invest in fixed deposits. As a result, the stock market will be affected negatively.
The same is true with government securities. If the interest rate increases before the retail treasury bond is issued, that would mean that treasuries would be more attractive investments than stocks. If you read about my post about the equity-bond theory, this is the concept behind it.
How does an increase in interest rates affect the stock market?
Now, what I’ve explained above is the interest rate’s effects on fixed deposits and government securities. Now what about the effects of high interest rates on stocks and mutual funds?
Here’s a simple explanation about it.
If the bank is paying you a 10% annual rate of return, the bank should charge their borrowers like 14% to 15% for the bank to gain profits.
Who are these borrowers? These are the people who have debts like mortgages, credit card loans and personal loans. They may also be companies that borrow money to spend on business expansion and operations.
Now let’s say a publicly listed company took a loan from the bank with a 15% annual interest rate, what happens is that the high borrowing costs would trigger the company to cut back on growth spending and in turn slow down the growth of the company. If the company has a high debt in their balance sheet to begin with, the company’s interest payments will be higher. As a result, the company will have lesser profits. So when profits go down, the stock price will also go down.
What if interest rates were lowered?
In an investor’s point of view, who would want to invest in a fixed deposit or a retail treasury bonds that only pays 1% annual return? If I’m an investor with a big pile of money, I’ll look for other investment vehicles where I can get bigger returns. This makes stocks and mutual funds a preferred choice for investments because when interest rates are low, companies and individuals borrow more money and spend more. As spending continues to increase, it boosts the economy and as a result, it also increases the stock prices.
In a borrower’s point of view, low interest rates would mean that I can borrow cheap money to spend in the economy. I can buy a house and a car without worrying about high borrowing costs. Banks and businesses can borrow money and go crazy with leverage. This stimulates wealth building and confidence in the economy but the drawback is that too much borrowing may result to higher debt levels and may also increase leveraging risks.
Conclusion
If interest rates go up, stock prices goes down. If interest rates go down, stock prices go up. Interest rates must be maintained in a level that will keep the economy balanced in the long term. High interest rates for prolonged periods of time makes fixed deposits and bonds a preferred investment compared to stocks and mutual funds but in turn lessens spending and slows down the economy. Low interest rates for prolonged periods of time makes stocks and mutual funds a better choice compared to fixed deposits and bonds. While low interest rates encourage borrowing and spending that results to economy growth, it also increases debt levels and leverage risks. It is important to understand how interest rates affect the stock market so that we can properly decide on where to invest our money.
Happy investing!
UPDATE: The Fed left interest rates unchanged. More on this development here.
The Federal Fund Rate is a basis for interbank borrowing to maintain its reserve as required by Fed… ( not the one on bonds and securities ) So if a bank wants to lend to others and it doesn’t have enough funds it will borrow from another bank and the basis for interest is the Fed Rate… If the fed rate is high…. it will discourage the bank from borrowing from others..
The fed is tightening their monetary policy. We should watch out for this on the coming months. When this happens, I think capital intensive industries will be directly affected.