The effect of interest rates on the stock market
Where many people with a saving account look forward to high-interest rates, high-interest rates on savings are rarely a cause for celebration for investors. When the European Bank announces that an interest rate increase is imminent, the stock prices drop immediately, but how is this possible?
What is the influence of interest on the stock market?
- An increase in interest rates makes borrowing more expensive.
- As a result, companies and consumers spend less money.
- This reduces the profitability of companies.
- As a result, share prices will fall with higher interest rates.
- Many investors switch from stocks to bonds.
When interest rates rise, borrowing money becomes more expensive
When interest rates rise, both consumers and businesses have to pay more to borrow money. Almost all companies borrow money from time to time, they do so to invest or to make a higher profit. Consumers also regularly borrow money to make purchases.
Companies invest less
Large companies borrow money regularly: they do this because they believe they can make a profit on their credit. When a company pays five percent interest over their loan and they achieve a return of seven percent on that, it means that they make a profit on their loan.
However, when interest rates rise, this profit margin decreases. Companies then borrow less money, which reduces investments. This can reduce the profitability of the company.
Investments decrease at higher interest rates
Current financing costs
Rising interest rates not only affect a company’s future investments. It can also lead to the current financing of the company becoming more expensive. When the company suddenly faces higher interest charges, the profitability of the company can be put under immediate pressure.
When earnings per share fall, shareholders are more likely to sell their shares, causing the price to fall.
Investors and borrowed money
Many investors make use of borrowed money within their portfolios. You can do this by applying leverage. When investors apply leverage, they invest on margin. The broker then deposits part of the investment. The investor has to pay interest when they use leverage.
When interest rates rise, the cost of using the margin increases. This makes investing with leverage less attractive. When interest rates rise sharply, investors may even decide to sell their shares out of panic. This can lead to a sharply declining share price.
A Decrease in overall consumption
In the previous paragraph we briefly discussed that companies will invest less when interest rates rise. Money is needed for major expansions and innovations.
When the interest rate on these investments increases, companies will postpone or cancel the less necessary investments altogether.
Decrease in employment
A direct consequence of the decrease in the number of investments is that companies spend less. When companies invest less, employment will decrease. After all, there are fewer projects for which people are needed. Lower employment in turn leads to less spending. The decrease in spending in turn leads to a decrease in sales. As a result, the profitability of the business sector decreases further, causing share prices to drop.
More expensive consumer credit
At the same time, consumers will spend less money because they will be able to purchase consumer goods on credit at a lower price. This also reduces spending. As a result, businesses will sell less and perform less well. This can also lead to falling share prices.
Investors withdraw their money from the stock market
Investors are always looking for an investment product with which they can achieve the highest return. When there is a higher interest rate, the return on savings accounts and bond loans is higher. At the same time, investors know that shares are less likely to do well.
Shares have always been investment products with a riskier image. Investors want to be adequately compensated for this. When bonds or even the average savings account become more attractive, more and more investors will sell their shares. As a result, share prices may fall further.
What can you do when the interest rate rises?
When interest rates rise, share prices will often fall. At the same time, returns on savings accounts and bond loans increase. It may then be wise to withdraw part of your money from the stock market and choose one of these less risky options.
Incidentally, it is also perfectly possible to profit from a rise in interest rates. For example, you can short sell shares using CFD’s. You will receive money when the price of the share falls.
You can also look for bargains. The higher interest doesn’t have to be permanent and in the future companies can achieve better results. When you want to buy shares, it is important to investigate carefully whether the company does not have huge debts on which they now pay much more interest.
How can you use the interest rate to predict economic recessions?
It is also possible to use interest rates to predict a future recession. Normally, the interest rates on short-term loans are lower than on long-term loans. Inflation causes the lender’s profitability to fall over a longer period. As a result of inflation, the same amount of money becomes worth less in the future. The lender, therefore, receives a smaller amount of real value back. Sometimes, however, there can be a reversed interest curve.
An inverse interest rate curve is a situation where the short-term interest rate is higher than the long-term interest rate. In the past, this was an indication of the start of a new recession. When this happens, it may be attractive to invest in short-term bonds. The interest rates on these bonds are then higher. In this situation, it is better to temporarily ignore shares.
On the Y as you see the interest rate and on the X as you see the number of years.
Note the real interest rate
It is important to pay attention to the real interest rate when analysing the market situation. How much the real interest rate rises depends on inflation. Inflation is the extent to which the average price level rises. When inflation increases, the value of the same amount of money decreases. When inflation is higher, the real interest rate increases less. A 1% increase in the interest rate at 1% inflation is stronger than a 1% increase in the interest rate at 3% inflation.
A higher interest rate does not necessarily have to be bad for the stock market. When the economy is doing well, interest rates can rise a bit without having a negative impact on the economy.
What about bonds?
The price of the same bond decreases as interest rates rise. After all, a bond with a fixed interest payment of 2% is more attractive when the interest rate on savings accounts is 1% than when the interest rate is 3%.
On new bonds, however, interest rates will be higher. If you think that the interest rate will drop again in the future, it may be interesting to buy bonds.
Investing in real estate
When interest rates rise, investing in real estate may become less attractive. When interest rates rise, your mortgage costs increase. At the same time, fewer people will be able to take out mortgages. This reduces the number of people who want to buy a house. As a result, house prices may fall.
How is the interest rate set?
Interest rates within economic zones are strongly influenced by the Central Banks. In America, for example, it is the Fed or Federal Reserve that sets interest rates. They change interest rates regularly to ensure that there is no excessive inflation.
By changing the interest rate it becomes cheaper or more expensive to get money. This strongly influences the spending pattern within an economy.
The effects of an interest rate increase or decrease can often be seen directly on the stock exchange. The actual effects on the economy can often only be seen a year later.
In the graph above you can see which interest rates the Fed has calculated over time
Which companies benefit most from low-interest rates?
When interest rates are very low, you see that companies that pay out high dividends often benefit the most: think of Shell, for example. Companies that have to finance many of their activities with borrowed money also benefit from low-interest rates: think of real estate companies.
Which companies benefit from high-interest rates?
Some shares perform better when interest rates rise. These are often the stocks in the financial sector. For example, banks may charge higher interest rates for lending money. This allows them to make a higher profit, which is of course good for the share price.
Expectations are key
Ultimately, it is the expectations that determine most of the effect of interest on the share price. The prices of shares are determined by the game of supply and demand. The expectations of millions of investors determine how share prices develop.
If the majority expect the Fed to cut interest rates by 0.5%, but they do so by 0.25%, share prices may still fall. People had already bought the shares based on that expectation. They are then disappointed by the more limited fall and decide to sell their shares.
It is therefore always important when investing in stocks to keep an eye on sentiment.
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When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.