What are the effects of interest rates on the stock market?

What is the ‘interest rate’?

The interest rate is a percentage that a lender of capital charges on the borrower’s debt repayment, usually paid out over a specified period. For example, when you take a loan from a bank, you’ll be charged interest on the principal amount you borrowed.

It’s also the value that the bank pays individuals for saving their money with them – calculated over a specified period.

There are many ‘interest rates’ in any economy, and they differ between institutions. However, the most important interest rate is set by central banks, and it affects all others.

• In the UK, it’s the ‘Bank Rate’ set by the Bank of England (BoE). It’s the rate at which other banks borrow from the BoE
• In the US, there are two – the Federal Funds Rate and the Federal Discount Rate. The first is the rate at which banks borrow from each other and the second is the rate at which banks borrow from the Federal Reserve (Fed)

When these are raised or lowered, the cost of borrowing charged by the banks to businesses, homeowners and consumers also increases or decreases. This essentially affects how much money people have left to spend in the economy.

In 2022, both the BoE and US Fed raised the interest rate by 0.25 percentage points, from 0.5% to 0.75%.¹ As a result, some of the other interest rates imposed by commercial banks were directly affected by changes to the Bank Rate, which include the following:

• Prime rate: this is the rate at which bank charge their best clients with a good record of repayment
• Credit rate: the interest rate levied on risky customers with a fair or sub-par credit rating that want to borrow money
• Mortgage rate: the rate at which mortgage is charged over a specified term

Below, we check how this move has impacted traders and investors in the stock market.

Why do central banks change the interest rate?

Central banks change the interest rate to control the rise of inflation.

For example, when inflation is too high, the central bank raises its interest rate. The hiked interest rate leads to less spending in the economy, which slows the rate of inflation.

Conversely, they lower the rate to stimulate the economy and increase spending, thereby promoting economic activity and growth.

How do interest rates affect stocks?

In principle, interest rates and stocks tend to move in opposite directions, not taking into account other events that influence the stock market. Whereas changes in interest rates take several months – or even years – to filter through the economy, stock markets react quickly to interest rate changes. That’s because it affects stock investors’ expectations about future stock performance.

Once the central bank increases the interest rate, there’ll be a domino effect on other charges that banks levy on their customers. In turn, banks will charge consumers more for credit, and weaken their spending power.

Deterred by the high credit rate, consumers will take fewer loans, and with what’s left of their money, they’ll have to pay more on existing credit. This ripple effect will decrease the aggregate disposable income in the country, and the demand for goods and services will slow down.

Public companies are not exempt from the effects of increased interest rates. There’ll be a higher cost of borrowing for business, including higher payments on current debt. The altered repayment plan will mean that there’s less profits on the books and ultimately, the share price could fall.

Note that the converse is also true. This causal loop will not occur for all company stocks – this is only a general principle. Different types of stocks will be affected in their own way. For example, growth stocks typically underperform relative to value stocks in high-interest rate environments.

Growth stocks underperform when interest is high

Growth stocks are burgeoning companies expected to grow and outperform the market. These stocks show potential of earning profit faster when compared to other companies. For example, tech stocks are often expected to grow quickly and appreciate a lot faster than other sectors.

Despite investors predicting that the performance of growth stocks will soar faster than the market, interest rates have often stood as a stumbling block to that potential being realised.

Companies often take out loans that they’re confident in paying back because they expect stable interest rates. Growth stocks are generally in their development stage, thus, borrowing money from the bank is crucial to realising its full potential.

When the central bank hikes interest rates, it becomes less attractive for investors to back growth stocks because they‘ll have less money in the business. The option of borrowing money from the bank will also be less desirable because there will be a hike in repayment on existing debt. When investors can’t make money, they might opt for more established, blue-chip value stocks that offer lower returns in exchange for security when interest rates are increased.

Value stocks offer relative security when interest is high

Value stocks, by contrast, are stocks of well-established companies that pay stable and regular dividends. These companies enjoy continued demand even during times when people spend less.

Moreover, financial sector shares like banks, mortgage lenders, credit providers, insurance providers, etc, may see share price appreciation as projected earnings from increased interest rates rise.

Value stocks perform better as they generally carry less risk than growth stocks, which means lower returns and dividends are acceptable to investors.

The relationship between interest, stocks and bonds

The relationship between interest rates and bonds follows an inverse pattern. That is, as interest rates rise, bond prices fall. This is because a bond’s price must adjust to remain competitive and attractive to investors when all the other rates change.

For example, let’s say you have a bond worth £1000 and it pays a fixed coupon amount of £50. That’s 5% interest.

When other rates increase above that, to say 5.26%, the bond price will have to fall to £950 to offer the same interest rate (5.26%) to remain competitive – given the fact that the coupon remains fixed at £50. [£50/ £950 x100 = 5.26%].

Typically, if interest rates are lower than the coupon rate on a bond, demand for that bond will rise as it represents a better investment. As demand increases, so too does the bond’s price.

On the other hand, if interest rates rise above the coupon rate of the bond, demand will drop – along with the bond’s price.

As bonds typically carry less risk than stocks, and now offer higher returns due to increased interest rates this new risk-reward profile becomes more attractive to investors, and they substitute away from stocks to bonds.

The opposite is also true. When interest rates go down, bond prices rise. Because bond is paid in a fixed amount, the principal of the loan will rise when interest rates drop so that only those who are willing and able to get pay the premium can get exposure.

As bond prices go up, only a few investors will get exposure to them. Stock prices will seem more attractive because investors will have more money to spend.

Learn more about bonds

How to take a position on interest rates

You can speculate on the future direction of interest rates in the short-term using contracts for difference (CFDs). You can go long or short to hedge against other investments that may be affected by changes in the interest rates such as mortgage repayments.

To get started, follow these steps:

1. Research your preferred market
2. Open an account or practise on a free demo
3. Select your opportunity
4. Set your position size and manage your risk
5. Place your deal and monitor your position

With over 17,000 markets available to you, there are several ways to take a position on the effects of interest rate announcements.

Trade using CFDs

Open a CFD trading account to:

• Speculate on share and ETF prices using derivates rather than owning any actual shares
• Trade on the prices of leading government bonds
• Go long or short on stock market index futures or options prices
• Remember that leverage trading magnifies both your profit and loss because it’s calculated based on the full size of the position, not just the deposit. That’s why you need to take steps to manage your risk.

Interest rates and the stock market summed up

• The interest rate is a percentage charged by the lender on the borrower’s debt repayment or reward for saving money at the bank
• The central bank is responsible for changing interest rates – in the UK, the Bank of England uses the Bank Rate to adjust rising inflation
• Interest rates and stocks move in opposite directions. When interest rates go up, stock prices go down and vice versa
• Growth stocks and value stocks are affected differently by changes in interest rates, with investors likely to opt for value stocks when interest rates go up because they offer more security
• You can speculate on the future direction of a range of global interest rates as well as take a position on stocks, bonds and ETFs

Footnotes

¹ Investment Monitor, 2022