Why Are High Interest Rates Bad for Stock Prices?
Stock prices are very volatile. They tend to change easily based on the news of the day, the success of and trends for the company that issued the shares and overall economic conditions. This is not uncommon--a piece of data in one financial area often affects all other financial areas. While many investors do not actively consider interest rates an important indicator of stock prices, interest rates do have an important effect; and the higher the interest rate is, the lower stock prices tend to fall.
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High Interest Rates
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Higher interest rates are a result of an increase in the federal funds rate, which in turn typically changes the bank rate. Banks use the bank rate as a general indication of where to set the rates for loans for properties, automobiles and all other types of loans. The banks do not want to set rates so high people will not be inclined to take out loans, but they use the bank rate as an indicator of the rate they will need to set to make money.
Investor Reaction
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Interest rates decrease general interest in the stock market when they rise, drawing investors to other types of investments. Bank-based investments like CDs increase in their rate of return, which gives investors a better deal for their money than investing in risky stocks. As a result, more and more investors use CDs and other bank mechanisms for their investments instead of purchasing stocks they perceive as less safe.
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Stock Reaction
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As investors pull out of the stock market, attracted by the high rates of interest that are increasing the rate of return on CDs, the stock market begins to suffer. With lower demand for stocks, stocks tend to experience a general drop in value. This begins a chain reaction that continues throughout most stocks as the market takes a more bearish approach and investors perceive better deals will be found elsewhere.
Overall Economic Conditions
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High interest rates can also indicate bad conditions for the entire economy, including the stock market. High rates make it much more difficult for people to afford properties or other assets where loan costs depend heavily on the interest rates that banks charge. This means people will tend to save their money rather than spend it or invest it in stocks, which leads to a downturn in the stock market.
Perception of Federal Funds Rate
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Many investors are well aware of this chain reaction that eventually pervades the stock market when interest rates change drastically. This can lead to hypersensitivity on the part of large investors, who see the federal funds rate increase and, assuming the future negative effects, will sell their shares. Smaller investors will mimic these larger investors, and the market will often take a turn for the worse before the banks can even begin thinking about their own rates.
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References
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