One of the most influential factors on stock prices might surprise you. You probably know that a company’s financials impact stocks – if a company makes more money, the stock price will trend upward in general. Conversely, if a company loses money, again, the stock price will trend downward in general. There are exceptions to this, but the profitability or perceived profitability most assuredly factors into the stock price.
However, there’s one aspect of the market that can have a remarkable impact on stock prices that you might not know about: interest rates. To understand how these rates influence equities, let’s first look at how the broader market works.
What Are Interest Rates?
You may have heard the phrase “interest rates are going down” on TV. Typically, this refers to the benchmark interest rate of the Federal Reserve.Â
Technically, interest rates (in particular, the Federal Funds Rate) affect the cost of borrowing. The Federal Reserve comprises a group of lenders, and this interest rate is what the banks use to trade reserves overnight. Or, put another way, think of the Federal Funds Rate as the rate that Bank of America or some other big financial institution pays on their loans.
When this Federal Funds Rate increases, money gets more expensive for banks. You can probably guess what happens then: banks pass those expenses down to customers. Car loans, credit cards, student loans, and even mortgages (to a lesser extent) all get more expensive for consumers. When the rate goes down, money is cheaper for the banks, and competition means that banks tend to make their lending products more affordable.
Therefore, even though these rates technically influence the cost of borrowing, they have more of an impact on the monetary supply. As rates go up, people can spend less because they are paying more in interest. Conversely, as rates go down, people can spend more and asset prices climb higher because it’s not as expensive to borrow money.
How Do Interest Rates Influence Stock Prices?
The Federal Funds Rate has a substantial impact on equity prices mainly because of how they affect consumers, companies, and investors.
When rates go up, three things will happen.
- For consumers, putting purchases on credit will become more expensive, meaning they can’t spend as much money. Rising rates may make obtaining credit more challenging due to higher payments, and it’s not uncommon to see banks cut credit lines so as not to overextend customers.
- Companies also find access to credit more difficult. Debt is more expensive, so they will typically need to be more conscientious about staff, purchases, equipment, and raising debt in the future. Companies become more cautious.
- Investors, on the other hand, begin to find debt-based investments more attractive. Bond yields, CDs, and mortgages all start a climb upwards.
With consumers restricting spending, higher interest rates potentially negatively impacting companies, and non-equity investments becoming more attractive, it’s easy to see why rising rates make stock prices trend lower. Diminished corporate bottom lines and debt yields make equities a less attractive investment from a risk-reward perspective.
Similarly, when rates go down, the opposite happens. Consumers can finance purchases more cheaply. Companies have easy access to credit, so they are far more willing to hire staff and raise funds. Finally, investors see less upside to debt investments, so equities become where they put their money.
Of course, none of this happens overnight. The Fed might change their rate, and it might take months for things to change. But, as a macrotrend, if the overall message the Fed is sending is that rates are on an upward trajectory, it’s reasonable to assume that equities will go down broadly. If the Fed signals rates are on the decline, again, broadly, one can assume that equities will go up.
What Is the Rate Right Now?
At the time of this writing, the target rate is 0.25%, but the effective rate is about 0.07%. Borrowing has not been this cheap since the fallout of the Great Recession! In 2019, before COVID, the percentage was up to 2.5%.
The Federal Reserve has not signalled any desire to increase the target rate. Even as the broader economy recovers, the Federal Reserve seems determined to keep the interest rate at or near 0%.Â
What Does This Mean for Your Investments?
While nobody can predict the future and past performance is never a guarantee of future returns, it would seem that the stock market could continue the same trajectory it has been on since the start of the pandemic if rates remain at historic lows. We believe in the next few quarters rates will rise and a hedged portfolio is the best way to capitalize in the current market. Or, put another way, other investments (like CDs or bonds) don’t look like they will be particularly desirable any time soon!
At M&A Wealth, we work with clients to create a financial roadmap to help them achieve their goals. If you’re interested in charting a course for your financial future, please contact us. We’d love to learn more about your story and see how we can help you navigate the world of equity, debt, and other investments!
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