Why Do Interest Rates Affect the Stock Market?

Yesterday, Wall Street closed the month in style, with all three major indices ending in the green for the second month running. Specifically, the Dow Jones, S&P 500 and Nasdaq composite closed yesterday’s session with daily gains of 2.18%, 3.09% and 4.41% respectively.

Wednesday’s surge on Wall Street was triggered by comments made by Fed Chair Jerome Powell during a speech at the Brookings Institute think tank in Washington, regarding the outlook for the US economy.

Investors were listening keenly for any hint about the Federal Reserve’s next moves ahead of their policy meeting in a couple of weeks. They were not disappointed.

Powell announced that, “it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down,” before adding, “The time for moderating the pace of rate increases may come as soon as the December meeting.”

Whilst these comments were largely in line with previous remarks emerging from the Fed in recent weeks, investors cheered the dovish tone. The response on Wall Street was almost instantaneous, as all three major US indices began to soar shortly after Powell took the stage.

But why are investors so bothered about interest rate hikes? How and why do they affect the stock market?

Inflation, Interest Rates and the Stock Market

Interest rates are the most important tool a central bank possesses in the battle against inflation. When inflation is high, as is currently the case, central banks normally raise rates in an attempt to bring inflation back down towards their target rate of around 2%.

Higher interest rates essentially reduce consumption and investment, which, in turn, puts downward pressure on prices. Higher interest rates work to combat rising prices in several ways:

• They increase the cost of borrowing, which discourages new borrowing to purchase big ticket items, such as a house or a car.
• Higher interest rates also increase the cost of servicing existing debt, which reduces consumers’ discretionary incomes. Less discretionary income = less spending, particularly on non-essential items.
• Consumers earn more interest on saving deposits at the bank, which encourages them to save money rather than spend or invest it.

As we described above and have witnessed countless times this year, changes in interest rates also have an impact on the stock market.

Generally speaking, the two have an inverse relationship. When interest rates rise, the stock market tends to move in the opposite direction, and vice versa. But what’s the logic behind this?

Rate Hikes and Share Prices

Above we highlighted how higher interest rates reduce consumption and, consequently, put downward pressure on prices. We looked at this strictly from a consumer’s perspective, but interest rates affect everyone, including businesses.

A rise in interest rates – and, consequently, a rise in the cost of borrowing - will affect businesses in a number of ways:

• Increased operating costs
• Less capital for investment in future growth
• A fall in sales due to lower discretionary income and reduced incentive for borrowing

Let’s look at these one by one.

Increased Operating Costs

The vast majority of businesses will have some level of debt on their books. Rising rates will increase the cost of servicing this debt, pushing up operating costs and, subsequently, reducing the company’s profitability.

Less Investment in Future Growth

A drop in profits means less money to invest back into the company for future growth. Furthermore, due to the increased cost of borrowing, the company may be less inclined to increase their credit for investment purposes.

A Fall in Sales

Rising interest rates means consumers have less money to spend, so they consume less. Who bears the consequences of this? Businesses.

Less consumption naturally translates to lower sales, which leads to lower revenue and, subsequently, lower profits. This reinforces the effect described above. As well as increased operating costs weighing on profits, a fall in sales also weighs, and even less capital is available for investment in future growth.

So What?

Lower profit and less investment in future growth reduces a company’s estimated future cash flow. All else being equal, this makes a company less attractive as an investment. Existing shareholders may be persuaded to sell their stake, and prospective investors may look for another destination for their capital, causing share prices to fall.

Naturally, everything described takes a while to filter through following an interest rate hike. However, the stock market doesn’t wait for these consequences to actually happen, it anticipates them and adjusts itself accordingly.

For this reason, any sign that there will be a change in interest rates will usually prompt a reaction in the stock market, as investors attempt to price in the anticipated outcome. Thus, yesterday, we saw a very positive reaction on Wall Street as investors digested Powell’s comments on interest rate rises.

Whilst rates will apparently continue to rise, the fact that these rises will be more restrained than previous increases was enough to improve sentiment amongst investors.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.