Interest rates and stock market returns are not directly tied to one another. Interest rates - the rate borrowers pay to lenders in exchange for the use of their money - are tied to the discount rate set by the Federal Reserve, to inflation expectations, to reinvestment patterns as borrowers pay off debt early to borrow at lower interest rates, and to the lenders' assessment of default risk with a particular issuer or industry. However, the stock market does affect interest rates indirectly, in a variety of ways.
Falling Markets and the Flight to Safety
When stocks are falling, many investors reassess their portfolios and begin shifting to less risky assets, such as bonds, cash, and permanent life insurance in a so-called "flight to safety." The flow of money into low-risk and risk-free investments represents an increase in the demand for bonds, CDs, money markets and other fixed-return investments. The laws of supply and demand then take hold: As demand for bonds increases, bond prices increase. Bond issuers simply do not need to pay high interest rates to attract capital which has been dissuaded by poor stock market returns. Conversely, bond buyers are willing to accept lower interest rates in exchange for relative safety of capital. As bond prices increase, interest rates fall.
Federal Reserve Policy
The Federal Reserve sets interest rates to manipulate the national money supply in response to market forces. If the Federal Reserve Board believes that the economy is contracting, or is in danger of contracting, or if they believe there is a possibility of deflation, they may act to lower short-term interest rates - the rates that banks pay one another to borrow reserves overnight. A rate decrease at the Federal Reserve flows quickly to the short-term bond market and affects the interest rates on CDs and money markets.
Federal Reserve Credibility
When the Federal Reserve lowers the discount rate, or increases the money supply through the purchase of large amounts of Treasury bonds on the open market, it is said to be stimulating the economy. If the Fed goes overboard, however, and pumps too much money into the economy, it could lead to inflation - a pattern of rising prices that occurs when too much money is competing for a limited supply of goods and services. The money supply has outpaced economic growth. If the Federal Reserve Board's policy is inflationary - or if the bond market thinks its policy will be inflationary, then the interest rates on long term bonds will tend to rise. This is to compensate lenders for the effects of inflation.
The Effect of Rising Stock Markets
Rising stock markets attract capital, and many investors then sell bonds in order to purchase stocks. When demand for bonds falls, bond prices fall, too, and interest rates rise, since bond issuers and borrowers must pay more to make themselves attractive to owners of capital. Rising stocks, then, tend to correlate with rising interest rates.
The Federal Reserve and Rising Stock Markets
If stock prices rise too far, too fast, the Federal Reserve board could take it as evidence the economy is overheating. They may move to increase short-term interest rates to restrain growth in order to avoid runaway inflation. They may also move to decrease the money supply by selling their portfolio of Treasury bonds and retiring that money from circulation. If they are successful, they will succeed in restraining inflation and keeping interest rates relatively low.