How Do Interest Rates Affect the Stock Market?

Interest rates refer to the cost someone pays to use another's money, usually a bank's funds. The central bank changes interest rates to reach targets and goals set by the bank. The impact on the stock market is shown as borrowing and becomes either more or less expensive for individuals and businesses, impacting overall consumer spending. 

The 2 are usually linked because of the impacts on spending, but the direct relationship is not always clear. The market involves a lot of forecasting, so no guarantee exists that prices will move based on specific actions. Learn more about how interest rates affect the stock market now.

Who Sets Interest Rates?

Interest rates constantly change because of the demands of lenders. Lenders want the most return, the least amount of risk and the highest levels of liquidity. 

The Federal Open Market Committee (FOMC) initially sets prime rates in order to manage the economy. It consists of 7 governors of the Federal Reserve Board and 5 Federal Reserve Bank presidents. The FOMC meets 8 times a year to determine the near-term direction of monetary policy and interest rates.

Although the committee influences rates to control inflation, it may increase rates to encourage saving, reduce spending limits and bring down inflation if inflation is too high. Essentially, it attempts to shrink the supply of money available to make purchases. On the other hand, if deflation is in effect, the committee may decrease rates to encourage consumer spending, as it becomes cheaper to borrow and the economy can improve.

The FOMC sets the base rate according to its own economic targets, and lenders set their own rates based on this rate. The rate impacts retail banks’ rates as they charge customers with similar interest, and it also is the rate banks charge each other for overnight loans. However, lenders’ rates can change based on individual needs, the market and the type of consumer. 

What Moves the Stock Market?

The stock market moves every day based on a number of factors. How much the stock market moves in reaction to the events is usually triggered by how big the event is itself and its impact on specific industries and economies. 

• Market sentiment: Sentiment is dictated by the current state of the market and investors’ confidence. If investors are more risk on, you may see prices move higher and the opposite will occur if the sentiment has a risk-off tone. 
• Economic factors: Changes in the economy such as tax increases, unexpected impacts or negative news may discourage investors or mean they have less money for investment, which can cause a negative effect on prices. Other economic factors such as consumer spending, business confidence or manufacturing and imports/exports can all impact individual stocks and the stock market. 
• Fundamental factors: Markets can move based on individual stock earnings such as its earnings per share or on industry and peer actions. A recent example of an earnings report impacting a stock and its peers is Snap Inc. (NYSE: SNAP). The company posted disappointing revenue growth and guidance. This action was due to Apple Inc.’s (NASDAQ: AAPL) rule change regarding advertising on mobile apps. The report resulted in Facebook Inc. (NASDAQ: FB), Twitter Inc. (NYSE: TWTR) and Pinterest Inc. (NYSE: PINS) shares falling the next day. 
• Inflation: Inflation tends to have an inverse correlation with valuations, as low inflation tends to drive the market higher. This condition shouldn’t be confused with deflation, which can be bad for the market. For clarity, deflation is a reduction in the price of goods and services.
• World events: World events are another aspect that can impact the stock market. For example, war, civil unrest and natural disasters have all had an impact on stock market movements. 
• Interest rates: Rates can dictate spending within the economy and can impact stability. Rate adjustments are used to control inflation. There has been a lot of recent talk about potentially raising rates, so it is vital to watch how the market moves in reaction. The current target for the federal funds rate is at a range of 0% to 0.25%.

Why Do Interest Rates Impact the Stock Market?

Interest rates impact the price of borrowing for different individuals. Although many factors influence the stock market, history suggests that interest rate changes can have strong ramifications. In addition, higher interest rates elevate short-term borrowing costs for institutions, which further influences other companies. This effect limits the amount of spending seen from consumers and investors as money ultimately becomes more expensive. 

When institutions face higher costs, they often increase the rates they charge; therefore, individual households are affected, and they will likely reduce their spending. As a result, confidence drops, and an impact on business earnings can occur. If this is the case, the stock market will likely see a fall in its prices. 

In the case of interest rates falling, opposite behaviors occur. Individuals have cheaper borrowing costs, encouragement to spend and better investment opportunities. Investing in stocks can send a company's share price higher, and spending from households can push up the company’s profits and earnings. Gains in the stock market will likely result.

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Interest Rates Play Their Part

The stock market moves every day. With a total market value currently of $95 trillion, many actions and events can impact its movement. Interest rates play a part in the valuation of stocks, and it is clear they are an essential part of keeping the economy and the market stable.  

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