How Do Interest Rates Affect Stock Prices?

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Interest rates are a tool used by the Federal Reserve Board to achieve stable economic growth. When the Fed changes interest rates, it affects the economy’s performance, including the performance of the stock market.

Considerations

  • As an investor researches a stock to make a purchase or selling decision, she considers many factors, including the company’s growth prospects, the current market conditions (which includes interest rates) and how buying or selling stocks fits in with her investment plans. Since the investors consider all of these factors, it is important to note that changes in stock prices can occur simultaneously due to all these factors.

Interest Rates and Earnings

  • The value of stock depends on the price per share. As a general rule, when a company’s earnings are expected to increase, its stock price will rise. Rising earnings for a company usually occur when the economy is growing, which occurs when interest rates are lowered. Similarly, when The Fed wants to dampen economic growth, they will raise interest rates. Rising interest rates will decrease a company’s earnings and cause stock prices to fall.

Interest Rates and Investors

  • Investors can choose to invest in stocks or bonds, and their investment choice is based on the expected returns of each investment. For example, suppose that the Fed decides to lower interest rates. When interest rates are lowered, bonds are issued with a lower interest rate. As a result, investors will realize they can earn more money by investing in stocks, and they will do so. When more people choose to invest in stocks, stock prices will start to rise. Similarly, when the Fed decides to raise interest rates, bonds will be issued with a much higher interest rate. This will encourage investors to purchase bonds, and as investors sell their stocks, stock prices will fall.

Interest Rates and Consumers

  • When the Fed decides to lower interest rates, consumers are encouraged to purchase items such as houses and cars because they can finance these purchases at lower interest rates. As consumers start to spend, they increase the earnings of companies. As investors notice the earnings of a company start to increase, they will purchase shares in the company and this will cause the stock price to rise. Similarly, if interest rates rise, consumers save their money. As consumers save, business earnings decrease. As investors see a decrease in business earnings, they sell stocks and stock prices fall.

Interest Rates and Businesses

  • When the Fed lowers interest rates, it decreases the cost of investing for businesses. Businesses start to expand and invest in more projects because investing is profitable. As a business starts to expand, investors purchase stock in the hopes of being able to sell in the future at a higher price. The increased purchase of stock causes stock prices to rise. Similarly, if the Fed decides to raise interest rates, a business will hold back on investing as it realizes that investing is less profitable due to the increased cost to invest. As investors notice decreased business investment, they assume the economy is starting to decline and sell their stocks, which causes stock prices to fall.

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References

  • “Financial Markets and Institutions”; Maureen Burton, Reynold Nesiba, Ray Lombra; 2004
  • “Canadian Securities Course: Volume One”; CSI Global Education Inc.; 2008
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