Any changes in the interest rates affect the financial market by increasing or decreasing the prices and profits of different assets. It is vital to understand the impact of an interest rate change on the equity market in order to make intelligent trading decisions.
In our article, we will learn how interest rates affect the stock market.
What happens when interest rates rise?
An increase in the interest rate means an increase in the borrowing cost since borrowers now have to pay higher interest to the financial institution while lending any amount. With a rise in the cost of borrowing, the customer’s spending decreases as bills become more expensive. Hence, disposable income decreases which in turn negatively impacts an individual’s investment in additional assets like the stock market. This leads to a fall in the profits and earnings of the businesses wanting to raise capital from the stock market.
What happens when interest rates fall?
A decrease in the interest rate means a decrease in the borrowing cost since borrowers now have to pay a lesser interest to the financial institution while lending any amount. With a fall in the cost of borrowing, the customer’s spending increases as bills become cheaper. Hence, disposable income increases which in turn positively impacts an individual’s investment in additional assets like the stock market. This leads to a rise in the profits and earnings of the businesses wanting to raise capital from the stock market.
Impact of interest rate on the stock market
Interest rates and the stock market moves in the opposite direction. When interest rates increase, stock prices decrease and vice versa. Any change in the interest rate affects the trader’s expectation about the stock market’s future performance.
When the central bank increases interest rates, it becomes costly for the companies to raise capital since they have to pay increased interest rates on the issued bonds. When raising capital becomes more expensive, profit expectations decline since earnings and growth are also hampered. When companies cut back on their growth and profits by raising lesser capital, the cash flows drop and decrease the company’s stock price. When a majority of companies witness a drop in their stock prices, the entire stock market starts declining due to the increased interest rates.
However, some stocks in the banking, brokerage, mortgage and insurance sectors increase in price when interest rates increase, as a rise in interest rates means that these firms can now charge more for lending. This impacts their profits positively and raises their stock market price.
On the other hand, when the central bank decreases interest rates, it becomes cheaper for companies to raise capital since they have to pay decreased interest rates on the issued bonds. When raising capital becomes less expensive, profit expectations increase since earnings and growth rate are amplified. When companies expand their growth and profits by raising more capital, the cash flows increase and raise the company’s stock price. When a majority of companies witness an increase in their stock prices, the entire stock market starts increasing due to the decreased interest rates.
Relationship between changing interest rates and the stock market
Interest rates and the stock market are inversely proportional. This means, if the interest rate rises, traders decrease their investment in the stock market as they fear that future earnings will fall. On the other hand, when the interest rate decreases, traders increase their investment in the stock market with an expectation of profits piling up in the future.
Let us discuss the different factors that define the relationship between interest rates and the stock market –
1. Company profits
When interest rates increase rapidly due to economic inflation, it impacts the company’s profits negatively. This happens because the stock market activities diminish, and capital-intensive industries are aggressively hit as they are not able to earn revenue by raising capital.
On the other hand, a decrease in interest rates contributes to the company’s profits and increases stock market activity. This helps companies raise higher capital at a lower cost and increases profits.
2. Domestic stock market participation
High interest rates also reduce domestic participation by traders in the stock market. Investors/traders shift to fixed-return assets or fixed deposits when increased rates increase, thus reducing domestic participation in the stock market. When investors pull out their investments from the stock market, demand for stocks decreases and supply increases, pushing the prices down even further.
On the other hand, when interest rates decrease, investors/traders start buying more stocks as it becomes less costly. This increases domestic stock market participation and thus raises stock prices even further.
3. Impact on small-scale companies
Increased profits impact small and medium-sized businesses the most. This is because banks impose higher profits on smaller companies compared to large multinationals. Hence, the first hit companies during an increase in interest rates are the ones having a turnover under 250 million AUD.
When interest rates are high, future company expansion and growth are negatively impacted as well. This is because increased interest rates lead companies to struggle to pay back loans and raise capital for higher revenue. This puts a hold on their existing expansion plans, and the focus shifts to repaying the money as soon as possible, which may also result in laying off employees. Companies end up cutting down on their spending and consumption, which decreases their demand for goods and services, reducing overall economic growth.
On the other hand, a fall in interest rate has a completely opposite impact on companies’ growth, profit and expansion.
Invest in the stock market, but when?
Investing in the stock market when interest rates are falling is a good opportunity. The stock market benefits from falling interest rates due to the inverse relationship between the investment’s value and interest rates. There is a greater opportunity for traders to benefit from the stock market when interest rates in the economy are low.
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