Interest Rates and Stock Prices
The relationship between interest rates and stock prices is of interest to stock investors as the market tends to react according to the general belief regarding the direction interest rates will take. While timing the market is usually not the best approach for most stock investors, it can help to understand how decisions and events that impact interest rates will affect stock prices.
What are Interest Rates?
Interest rates are simply the costs associated with borrowing someone else’s money. The Federal Reserve (“the Fed”), through the federal funds rate, uses interest rates as a tool to help stabilize economic growth. In managing interest rates, the Fed seeks to manage the rate of inflation. By raising rates, for example, the Fed sends a message that it wants to slow down the rate of borrowing (more dollars out there chasing goods) in order to keep prices from rising too quickly.
How Interest Rate Moves Impact Stock Prices
Whenever the federal funds rate increases, it makes it more expensive for banks to borrow money from the Fed. The impact of this increase trickles down so that both businesses and individuals are impacted. Individuals become less likely to borrow and discretionary spending by consumers is likely to decline. Similarly, businesses are less likely to fund growth and expansion as the cost of borrowing money to fund that growth and expansion goes up.
Generally speaking, stock prices are a reflection of the future expectations of a company. As the prospects for a company are perceived as less strong due to lower demand for its products and services (because spending has decreased) the stock price becomes more likely to decline. The discounted cash flow (DCF) valuation model is the best example of a stock valuation approach the directly factors in a company’s future cash flows.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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