When the next Federal Reserve meeting is expected to bring interest rate cuts or increases, it is wise, as a stock investor, to be aware of the potential effects behind such decisions. Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. Here's why.

A decrease in interest rates means that those people who want to borrow money enjoy an interest rate cut. But this also means that those who are lending money, or buying securities such as bonds, have a decreased opportunity to make income from interest. If we assume investors are rational, a decrease in interest rates will prompt investors to move money away from the bond market to the equity market. At the same time, businesses will enjoy the ability to finance expansion at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices. Investors and economists alike view lower interest rates as catalysts for expansion.

Overall, the unifying effect of an interest rate cut is the psychological effect it has on investors and consumers; they see it as a benefit to personal and corporate borrowing, which in turn leads to greater profits and an expanding economy.

For more information, see the article Forces Behind Interest Rates, and this tutorial on the Federal Reserve.

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