As central banks increase interest rates around the world, lenders are having to tighten their belts. Homeowners with mortgages have had an easy ride over the last few years as the cost of borrowing hit all time lows in many markets across the world.
The Federal Reserve has raised rates twice this year, the first interest rate increase since 2018, and the Bank of England has increased rates four times since December. Interest rates will continue to rise around the world this year as global supply shocks take a grip.
At times like these investors may wonder how interest rates will affect the stock market. Interest rates and stock market performance is related, though the effects of rate movements may not take immediate effect. There also isn’t a one-on-one correlation between interest rate and stock price movements.
How Do Interest Rates Work?
Interest rates determine the cost of borrowing. They’re under the control of the central banks and they determine at what cost other banks may borrow funds. This, in turn, affects the cost at which individuals and businesses can borrow money. Central banks use interest rates to control spending. In this way they help to manage the economic activity in the country. Most banks have targeted inflation levels as their primary goals.
Central banks raise interest rates to curb rising inflation. The increased cost of borrowing reduces the demand for products and services. Consumers and businesses have less disposable income as they have to service their debt repayments. Most are also unwilling to borrow at the higher interest rates.
How Do Increased Interest Rates Affect Stock Prices?
Reduced demand constraints growth. The increased cost of financing business operations and the reduction in demand reduces profitability. There is a knock-on effect on estimated future cash flows, the basis on which stocks are valued. As a result, investors are less interested in buying shares. Some investors may see equities as too risky and invest their money in other financial assets such as commodities or the money market instead.
Higher interest rates act as an incentive for investors to sell off and make profits while the going is good. This is particularly true this year as global stock markets have seen a couple of years of double-digit share price growth. This is often a short-term effect. History shows that stock markets will bounce back from the initial reaction to the increased interest rates.
Interest rate hikes also don’t affect every sector in exactly the same way. Certain sectors, like financial stocks and insurance, may benefit from interest rate rises. They can make better margins when interest rates are higher and this reflects in the stock price. Shares in growth industries, like tech, will typically take the hardest knock in a rising interest rate environment. This is because growth requires cash and when borrowed money becomes more expensive, these businesses may have to hold back on growth and investment.
On the other hand, when interest rates fall, borrowing becomes less expensive, increasing disposable income and demand. Investors who have their money in safe havens like fixed deposits and the money market will earn less interest and may decide to reinvest in stocks to maximize their profits. New money flowing into the stock market will raise the price of shares.
The increased demand for goods and services will enhance growth prospects. In this environment businesses are also more likely to invest in growth, increasing business value along with the shares.
A Diversified Portfolio Mitigates Risk
Interest and stock prices tend to move in opposite directions. However, investor expectations and sentiment also play a role. For investors, the best way to reduce risk is to ensure that you have a diversified financial portfolio and that you stick to the goals of your financial strategy. For novice investors and business owners that will start from scratch these are few things they need to know. But as most stock market investors are in it for the long run and over the long run, stocks have proven to be resilient financial instruments.