INTRODUCTION

The Federal Open Market Committee (FOMC), comprising seven governors of the Federal Reserve System System Board and five Federal Reserve Bank presidents, sets the target for the federal funds rate. As a result, the rate at which banks borrow from and lend to every other overnight—features a ripple effect across the whole U.S. economy, including the U.S. stock exchange. And, while it always takes a minimum of 12 months for a change within the interest rate to possess a widespread economic impact, the stock market’s response to a change is usually more immediate.

The rate of interest That Impacts Stocks

The rate of interest that impacts the stock exchange is that of the federal funds rate. The federal funds rate is also referred to as the discount rate because depository institutions are charged for borrowing money from Federal Reserve System banks.

The Federal Reserve System makes adjustments to the federal funds rate to regulate inflation. By increasing the federal funds rate, the Federal Reserve System is effectively attempting to shrink the availability of cash available for creating purchases. This makes money costlier to get. Conversely, when the Federal Reserve System decreases the federal funds rate, it increases the cash supply. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns.

What Happens When Interest Rates Rise?

When the Federal Reserve System increases the discount rate, it doesn’t directly impact the stock exchange. The sole direct impact is that borrowing money from the Federal Reserve System is costlier for banks. It happens because any increases within the discount rate have a ripple effect throughout the economy.

Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So, individuals consumers are impacted through increases to their MasterCard and mortgage interest rates, especially if these loans carry a variable rate of interest. When the interest rate for credit cards and mortgages increases, the quantity of cash that buyers can spend decreases.

Consumers still need to pay their bills. When those bills become costlier, households are with less income. When consumers have less discretionary pocket money, businesses’ revenues and profits decrease.

What Happens When Interest Rates Fall?

When the economy is slowing, the Federal Reserve System cuts the federal funds rate to stimulate financial activity. A decrease in interest rates by the Federal Reserve System has the other effect of a rate hike. Investors and economists alike view lower interest rates as catalysts for growth—a benefit to non-public and company borrowing. This, in turn, results in greater profits and a strong economy.

Consumers will spend more, with the lower interest rates making them feel that, perhaps, they will finally afford to shop for that new house or send their kids to a private school. In addition, businesses will enjoy the power to finance operations, acquisitions, and expansions at a less expensive rate, increasing their future earnings potential. So, naturally, this results in higher stock prices.

Particular winners of lower federal funds rates are dividend-paying sectors, like utilities and land investment trusts (REITs). Additionally, large companies with stable cash flows and robust balance sheets enjoy cheaper debt financing.

If a corporation is seen as curtailing its growth or is a smaller amount profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop. All else being equal, this may lower the worth of the company’s stock.

Interest Rates and therefore the Bond Market

Interest rates also impact bond prices and therefore, the return on the certificate of deposits (CDs), Treasury bonds, and Treasury bills. There’s an inverse relationship between bond prices and interest rates: as interest rates rise, bond prices fall (and vice versa). The longer the bond’s maturity, the more it fluctuates by changes within the rate of interest.

When the Federal Reserve System raises the federal funds rate, newly offered government securities–such as Treasury bills and bonds–are often viewed because of the safest investments. This is because they’re going to experience a corresponding increase in interest rates usually. In other words, the risk-free rate of return goes up, making these investments more desirable. However, because the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the specified risk premium decreases while the potential return remains an equivalent (or dips lower), investors may feel stocks become too risky and can put their money elsewhere.

The measure of a bond’s price sensitivity to a change in interest rates is named the duration.

One way governments and businesses raise money are thru the sale of bonds. As interest rates move up, the value of borrowing becomes costlier. This suggests that demand for lower-yield bonds will drop (causing their price to drop). As interest rates fall, it becomes easier to borrow money, causing many companies to issue new bonds to finance new ventures. This may cause the demand for higher-yielding bonds to extend, forcing bond prices higher. Issuers of callable bonds may prefer to refinance by calling their existing bonds so that they can lock during a lower rate of interest.

CONCLUSION

Although the connection between interest rates and therefore, the stock exchange is relatively indirect. The two tend to maneuver in opposite directions—as a general rule of thumb when the Federal Reserve System cuts interest rates. It causes the stock exchange to travel up; when the Federal Reserve System raises interest rates, it causes the stock exchange to travel down. But there’s no guarantee on how the market will react to any given rate of interest change.

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