What does a cut in interest rates mean for the stock market?

By Investopedia Staff AAA
A:

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.

RELATED FAQS

  1. What exactly is being done when shares are bought and sold?

    Most stocks are traded on physical or virtual exchanges. The New York Stock Exchange (NYSE), for example, is a physical exchange ...
  2. Are oil prices and interest rates correlated?

    Yes. No. Maybe. Definitely. There's no easy answer to this question. While many theories abound, the reality is that oil ...
  3. Who determines interest rates?

    In countries using a centralized banking model, interest rates are determined by the central bank. In the first step of interest ...
  4. How does FINRA differ from the SEC?

    With all the financial organizations out there, knowing what they all do can be as complicated as knowing where to invest. ...
RELATED TERMS
  1. ICE LIBOR

    See LIBOR
  2. LIBOR

    LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate ...
  3. Interest Rate Index

    An index that is based on the interest rate of a financial instrument ...
  4. LIBOR Scandal

    A scandal in which financial institutions were accused of fixing ...
  5. Global Recession

    An extended period of economic decline around the world. The ...
  6. Economic Exposure

    A type of foreign exchange exposure caused by the effect of unexpected ...
comments powered by Disqus
Related Articles
  1. Spotting A Market Bottom
    Bonds & Fixed Income

    Spotting A Market Bottom

  2. Introduction To Asian Financial Markets
    Economics

    Introduction To Asian Financial Markets

  3. How Influential Economists Changed Our ...
    Fundamental Analysis

    How Influential Economists Changed Our ...

  4. The Dark Side Of The WTO
    Economics

    The Dark Side Of The WTO

  5. Investment Misselling A Global Problem
    Personal Finance

    Investment Misselling A Global Problem

Trading Center