The investment community and financial media tend to obsess over interest rates and for a good reason. Interest rates refer to the cost someone pays for the use of someone else's money.

When the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents, sets the target for the federal funds rate—the rate at which banks borrow from and lend to each other overnight—it has a ripple effect across the entire U.S. economy, including the U.S. stock market. And, while it usually takes at least 12 months for a change in the interest rate to have a widespread economic impact, the stock market's response to a change is often more immediate.

Key Takeaways

  • When the Federal Open Market Committee (FOMC) changes the interest rate, it impacts both the economy and the stock markets because borrowing becomes either more or less expensive for individuals and businesses.
  • Any impact on the stock market to a change in the interest rate changes is generally experienced immediately, while, for the rest of the economy, it may take about a year to see any widespread impact.
  • Higher interest rates tend to negatively affect earnings and stock prices (with the exception of the financial sector).

Understanding the relationship between interest rates and the stock market can help investors understand how changes may impact their investments. They can also be better prepared to make better financial decisions.

The Interest Rate That Impacts Stocks

The interest rate that impacts the stock market is the federal funds rate. Also known as the discount rate, the federal funds rate is the rate depository institutions are charged for borrowing money from Federal Reserve banks.

The Federal Reserve makes adjustments to the federal funds rate in order to control inflation. By increasing the federal funds rate, the Federal Reserve is effectively attempting to shrink the supply of money available for making purchases. This, in turn, makes money more expensive to obtain. Conversely, when the Federal Reserve decreases the federal funds rate, it increases the money supply. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns.

Below is a chart that shows fluctuations in the federal funds rate over the past 20 years:

The federal funds rate is significant because the prime interest rate—the interest rate commercial banks charge their most credit-worthy customers—is largely based on the federal funds rate. It also forms the basis for mortgage loan rates, credit card annual percentage rates (APRs), and a host of other consumer and business loan rates.

What Happens When Interest Rates Rise?

When the Federal Reserve increases the discount rate, it does not directly impact the stock market. The only direct impact is that borrowing money from the Federal Reserve is more expensive for banks. The impact is due to the fact that any increases in the discount rate have a ripple effect throughout the rest of the economy.

Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So, individuals consumers are impacted through increases to their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.

Consumers still have to pay their bills. When those bills become more expensive, households are left with less disposable income. When consumers have less discretionary spending money, businesses' revenues and profits decrease.

Businesses are not just impacted indirectly (due to a decrease in consumer spending). They are also impacted directly because they also borrow money from banks to run and expand their operations. When the banks make borrowing more expensive, companies may not borrow as much and will pay higher rates of interest on their loans. Less business spending can slow the growth of a company—it may curtail expansion plans or new ventures, or even induce cutbacks. There may be a decrease in earnings as well, which, for a public company, usually affects its stock price negatively.

What Happens When Interest Rates Fall?

When the economy is slowing, the Federal Reserve cuts the federal funds rate to stimulate financial activity. A decrease in interest rates by the Federal Reserve has the opposite effect of a rate hike. Investors and economists alike view lower interest rates as catalysts for growth—a benefit to personal and corporate borrowing. This, in turn, leads to greater profits and a robust economy.

Consumers will spend more, with the lower interest rates making them feel that, perhaps, they can finally afford to buy that new house or send their kids to a private school. Businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential. This, in turn, leads to higher stock prices.

Particular winners of lower federal funds rates are dividend-paying sectors, such as utilities and real estate investment trusts (REITs). Additionally, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing.

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How Interest Rates Affect the Stock Market

Interest Rates and the Stock Market

If a company is seen as cutting back on its growth or is less profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company's stock.

If enough companies experience declines in their stock prices, the whole market, or the key indexes many people equate with the market—the Dow Jones Industrial Average, S&P 500, etc.—will go down. With a lowered expectation in the growth and future cash flows of a company, investors will not get as much growth from stock price appreciation. This can make stock ownership less desirable. Furthermore, investing in equities can be viewed as too risky when compared to other investments.

However, some sectors stand to benefit from interest rate hikes. One sector that tends to benefit the most is the financial industry. Banks, brokerages, mortgage companies, and insurance companies' earnings often increase–as interest rates move higher–because they can charge more for lending.

Interest Rates and the Bond Market

Interest rates also impact bond prices and the return on certificate of deposits (CDs), Treasury bonds, and Treasury bills. There is an inverse relationship between bond prices and interest rates: as interest rates rise, bond prices fall (and vice versa). The longer the maturity of the bond, the more it fluctuates in accordance to changes in the interest rate.

When the Federal Reserve raises the federal funds rate, newly offered government securities,–such as Treasury bills and bonds–are often viewed as the safest investments. They will usually experience a corresponding increase in interest rates. In other words, the risk-free rate of return goes up, making these investments more desirable. As the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same (or dips lower), investors may feel stocks have become too risky and will put their money elsewhere.

The measure of the sensitivity of a bond's price to a change in interest rates is called the duration.

One way governments and businesses raise money is through the sale of bonds. As interest rates move up, the cost of borrowing becomes more expensive. This means demand for lower-yield bonds will drop (causing their price to drop). As interest rates fall, it becomes easier to borrow money, causing many companies to issue new bonds to finance new ventures. This will cause the demand for higher-yielding bonds to increase, forcing bond prices higher. Issuers of callable bonds may choose to refinance by calling their existing bonds so they can lock in a lower interest rate.

For income-oriented investors, a reduction in the federal funds rate means a decreased opportunity to make money from interest. Newly-issued treasuries and annuities won't pay as much. A decrease in interest rates will prompt investors to move money from the bond market to the equity market. The influx of new capital causes the equity market to rise.

Impact of Expectations

Nothing has to actually happen to consumers or companies for the stock market to react to interest-rate changes. Rising or falling interest rates can also impact the psychology of investors psychology. When the Federal Reserve announces a hike, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop, and the market may tumble in anticipation. On the other hand, when the Federal Reserve announces a cut, the assumption is consumers and businesses will increase spending and investment. This can cause stock prices to rise.

If expectations differ significantly from the Federal Reserve's actions, these generalized, conventional reactions may not apply. For example, suppose that the Federal Reserve is expected to cut interest rates by 50 basis points at its next meeting, but they instead announce a drop of only 25 basis points. The news may actually cause stocks to decline because the assumption of a cut of 50 basis points had already been priced into the market. 

832

The number of points the Dow dropped on Oct. 10, 2018, due to the fear of higher interest rates. That said, the Dow also dropped even more significantly in March 2020 as the Fed cut rates to near zero amidst the global coronavirus pandemic.

The business cycle, and where the economy is in it, can also affect the market's reaction. At the onset of a weakening economy, a modest boost provided by lower interest rates is not enough to offset the loss of economic activity; stocks may continue to decline. Conversely, toward the end of a boom cycle, when the Federal Reserve is moving in to raise rates—a nod to improved corporate profits—certain sectors often continue to do well, such as technology stocks, growth stocks and entertainment and recreational company stocks.

The Bottom Line

Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions—as a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as to how the market will react to any given interest rate change.