Investing > How Do Interest Rates Affect Stocks?

How Do Interest Rates Affect Stocks?

Interest rates have an impact on pretty much everything in the stock market—and every rate change is an opportunity for investors.

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Updated September 16, 2022

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We are all living on borrowed time, and most of the stock market is living on borrowed money. 

On February 28th, 2022, the total margin debt in the U.S. was just about $835 billion. Naturally, with that much debt driving the market, interest rates can make a difference between life and death for some stocks in our portfolios.

Just imagine: When interest rates are low, that means that all the big financial institutions can buy stocks with borrowed cash, companies have access to cheap debt to invest in themselves, and consumers can buy more stuff. It is an ideal scenario for growth all-around, right? 🤔

Well, the strange thing is, this isn’t always the case—bullish periods in the past have been correlated with increasing interest rates and some assets actually do better when rates rise. And of course, there are even assets that are seemingly unaffected by the FED’s enlightened whims, which means that making a balanced, adaptive portfolio is not that hard.

In this article, we will discuss exactly how the FED-prescribed interest rates work, how they impact the rates we’re offered by banks, and how these changes affect stocks and other major investments. So, since interest rates aren’t going any lower, let’s not lose any valuable time and jump right in. 👇

What you’ll learn
  • Definition of Interest Rates
  • The Link Between Stocks and Interest Rates
  • What Happens When Interest Rates Go Up
  • What Happens When Interest Rates Go Down
  • How Expectations Can Have an Impact
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

Defining Interest Rates 👨‍🏫

A general definition of interest rate is the amount the lender charges the borrower for a loan. However, when we talk about how interest rates impact the markets, we’re referring to a very specific area—the rates at which banks can borrow from the Federal Reserve and other commercial banks.

This is important for the stock market because when financial institutions can borrow at affordable rates, they tend to invest that borrowed cash in the market—this is why stocks often go up when interest rates go down and vice-versa. And unlike personal and business loans that we can get from a bank, on a federal level interest rates are much lower.

Before we go any further, we just have to distinguish between 2 types of FED-prescribed rates: The first type is called the discount rate—this is the rate at which banks can directly borrow from the FED. To incentivize banks to borrow from each other, the FED usually makes this rate higher than the other type of rate called the federal funds rate.

Understanding the Federal Funds Rate 📓

We all know that banks love to lend money—but they love to borrow as well. And what they love more than anything is to borrow at a low rate and then lend that same money at a higher rate.

That’s where the FED comes in—the federal funds rate (FFC) is the interest that banks have to pay when they borrow from other commercial banks, and it is normally lower than the discount rate at which banks borrow from the FED. Here is how this rate is set:

8 times a year, a body called the Federal Open Market Committee (FOMC) determines the federal fund rate with the agenda of strengthening the economy. The FOMC then advises commercial banks to use it.

Banks are not legally obligated to use the interest rate determined by the FED—the rates themselves are set naturally according to supply and demand in the debt market, as well as the amount of cash reserves in commercial banks. This is where a bit of creativity is needed from the central bank.

Visual chart of fluctuating value of the FFR, since the 1980s.
Since the 1980s, the FFR has gradually been dropping from 19% to its all-time low of 0.05%—this trend coincided with a period of secular stock market growth. Image by TradingVew.

Since the determined federal funds rate needs to be respected for the FOMC’s economic plan to work, the FED can step into the open markets if necessary and influence real interest rates by using monetary policy tools to change the supply of credit and money in the market.

In essence, this means the FED will buy and sell government securities in order to drive supply and demand in whichever way it needs to. All in all, it takes a while before the effective federal funds rate reaches the desired level and is felt in the economy, but the stock market usually reacts as soon as news about a FOMC decision drops.

The Relationship Between Stocks and Interest Rates Explained 🔗

Interest rates are always the talk of the town among stock and bond investors. This is because interest rates can have a major impact on the prices of securities either directly or indirectly.

Imagine this: A huge financial institution gets word that interest rates are lower now and they can borrow money more cheaply than before. They decide to buy a lot of securities and the stock market goes up due to this injection of capital.

But the story doesn’t end there because the companies that are listed on the stock market also have access to cheaper debt—which means they can expand more easily. As this looks good for those companies, retail investors decide to buy using their margin trading accounts and that drives stock prices up even further. The opposite is also possible: When interest rates go up, stocks often go down in anticipation of the markets slowing down.

This is just an oversimplified version of the story—the truth is that interest rates are just one factor that determines the destiny of stocks, so it is possible for the scenario we described above to not play out in this way. 

Now, what always happens is that stocks aren’t affected by interest rate changes but by news of interest rate changes. However, not all stocks are affected equally as some are more sensitive to the cost of borrowing than others.

Stocks and Interest Rate Sensitivity 📊

Even though most stocks like low interest rates, some play by different rules. One such example is finance stocks—banks make money through short-term borrowing and long-term lending, so when there’s a long-term trend of high interest rates, banks will generate more income. This is not the only factor that impacts the prices of bank stocks, but it is an important one.

However, stocks that do worse when interest rates are higher are more common. First of all, industries that use a lot of debt like construction companies are heavily impacted by interest rates. Moreover, growth stocks often fund their expansion—which is their most attractive aspect—through debt, and if debt becomes expensive, they might lose their momentum on the market and have a bad time.

Then there are industries that pay a lot of dividends: REITs, utilities, and telecommunication companies are just some. Since dividend stocks generate income, they are often good substitutes for bonds when interest rates are low. However, when interest rates go up, bonds become more alluring, and dividend stocks have to make up for their lower yields and inherent risk with a cheaper price.

Some of the types of stocks that are very influenced by interest rates include:

  • ☑ Homebuilders
  • ☑ Banks
  • ☑ Financial stocks
  • ☑ Growth stocks
  • ☑ Dividend stocks

What Happens to Stocks When Interest Rates Go Up? 📈

We’ve all heard that when interest rates go up, stocks go down—that is the general rule of thumb, and that is what has usually occurred when interest rates were increased historically. Essentially, when interest rates go up, debt is more expensive, investors and institutions have a harder time buying stocks using debt, and companies have a harder time growing without cheap loans.

Visual double line chart depicting the aftermath of lowered interest rates before the Dotcom crash in 2000
In the 80s and 90s, the lowering of interest rates was followed by a stock market boom that ended with the Dotcom crash of 2000. Image by TradingView.

But as we already mentioned, interest rates are just one of many factors that determine stock prices, so an increase in interest rates can well be accompanied by a bull market. Here’s an example:

In the period after the Dotcom crash, the markets experienced a steady rally that reached its peak in late 2007. During this time, the federal funding rate went from being under 1 percent to around 5.25%—the growth of the stock market after the Dotcom crash was correlated to the increase in interest rates.

Double line graph indicating the correlation between interest rates and stock market movements from the late 90s.
The increases in interest rates correlated with stock market movements since the late 90s up until the Great Recession when the two trends diverged. Image by TradingView.

Moreover, during this period, the yields of 10-year Treasury bonds moved with the stock market up until 2009 when they diverged. When looking at all of this, we can see that an increase in interest rates can be bullish for the stock market—but only up to a certain point.

Since higher interest rates counteract inflation and reduce the levels of overbuying and volatility in the markets, a more hawkish FED monetary policy can be seen as a way of stabilizing the markets in the long term.

In other words, the gradual interest rate increase that started in 2003 was seen as a positive force in the market, and thus, stock prices and bond yields mirrored each other during this period. But let’s not forget that it is more common for the stock market to contract when interest rates go up.

Whether this or its opposite will happen depends on the situation—interest rates are just one, albeit very important number in this whole equation, so it is important to also look at things like inflation, the state of the economy, whether the market is overpriced, etc. before making a prediction about what an interest rate increase will do to your portfolio.

💡 Worried about inflation? Learn about the relationship between inflation and stocks.

What Happens to Stocks When Interest Rates Go Down? 📉

Saying that stocks go up when interest rates go down might turn out true some of the time, but it is an oversimplification. Rising interest rates have often been accompanied by greater economic and earnings growth—and so, higher rates have more often than not been associated with higher, not lower stock prices.

But what happens at the moment when interest rates go down and why? For one, when interest rates are lower, this means easier access to debt for companies, financial institutions, investors, and consumers. Consumers spend more money and buy houses, college tuitions, and other products that might be too expensive otherwise.

During this time, companies see more earnings and since debt is cheap, they can borrow in order to expand their business with this newfound cash. Naturally, if this goes well, the stock prices of those companies go up as well. Seeing this, financial institutions borrow in order to buy stocks that will appreciate soon, and retail investors jump on the bull wagon as well and buy value stocks at a discount.

In a scenario where interest rates were high previously and come down recently, we often see this natural economic and stock market growth. However, when very low interest rates increase, this can also be seen as a very positive force in the economy.

Visual double line chart highlighting stock prices and interest rates before the Great Recession, and after the COVID crash era
The period before the Great Recession had high stock prices and interest rates, and the COVID crash era was characterized by extremely low rates. Image by TradingView.

High rates protect the economy against inflation, making it harder for a stock market bubble to form. Since credit requirements are higher when rates are high, a period like this is prone to have fewer delinquencies and bad business practices like those that were rampant just before the crash of 2008.

To be precise, delinquency rates rose from an average of 1.7% to 4.5% by the second quarter of 2008—this was in part due to loans being so cheap and easy to get.

All in all, even though low rates give a signal to everyone in the economy that good times are coming and that they can spend more, overreliance on cheap cash can lead to all sorts of problems over the long term—one being inflation, which was the FEDs main reason for increasing interest rates in 2022.

Therefore, what interest rates will do to the stock market depends on the current economic situation. Even though lower rates make the markets more alive, when they are too low, they can bring problems that will suddenly make higher rates look like a blessing.

Bonds and the Impact of Interest Rates 📚

Like tides and ships, interest rates and bonds have a strong relationship—as soon as interest rates change, their effects can be felt in the bond market. This relationship is inverse, meaning that when interest rates go up, bonds generally go down, and vice-versa.

Now, this must sound counterintuitive—after all, when interest rates are higher, bond yields are higher too. That means that bonds have higher returns and are, therefore, more valuable. 

But a bond issued in a low interest rate period will become unprofitable when rates rise and new bonds with higher yields step onto the stage, and thus, older bonds must be sold at a discount to make up for their lower yields.

Here is how this works on an example: Let’s say that interest rates are exactly 10% right now. We buy a $1,000 bond with a 2-year maturity and an annual coupon of 10%. This means that we will pay $1,000 for the bond, and we will receive the coupon (10%) as payment every year until maturity—this is 100 bucks per year for 2 years. 🗓

And finally, when 2 years have passed and the bond has matured, we get our $1,000 as well. We end up with $1,200 in total. Not a bad deal at all, but what happens if interest rates go up one day after we’ve bought our 10% bond?

Let’s say that the new rates are significantly higher and that anyone can find bonds with a 15% coupon on any top investment app for the same price and with the same maturity period. Now, we can buy a 15%-per-year bond that will give us annual payments of 150$ for the same price, which is just categorically better than the old bond we’ve already bought.

Bonds with 2-Year MaturityBond PriceTotal Coupon Payments After 2 YearsTotal Expected Return After Maturation Date
Bond 1 (10% coupon)$1,000$200$1,200
Bond 2 (15% coupon)$1,000$300$1,300
Bond 3 (5% coupon)$1,000$100$1,100

And, if interest rates are lowered instead, newly-issued bonds become less profitable, and therefore, we can sell our higher-yield bonds at a better price. From the table above, we can see that based on their coupons, some bonds are simply better than others. 

So if we buy a bond with a 10% coupon and interest rates go up the next day, making 15% bonds the new standard, we must offer our bond at a discount if we want to sell it now. Since the difference in the total value of the two bonds is $100, we must make up for that difference with our discount—that is how interest rates impact bond prices.

Impact of Interest Rates on Other Investments 🕵️‍♂️

Interest rates can have an impact on alternative assets as well—these are all assets that aren’t stocks, bonds, or cash. After the multiple economic rollercoasters we’ve ridden in the past few years, and especially after the COVID-19 pandemic started, over 80% of investors now say that they are considering investing in more alternative assets in today’s volatile market.

First of all, let’s split alternative assets into 2 bite-sized categories: Assets that are oppositely correlated with interest rates, and assets that are not significantly related to interest rates.

Assets that generally rise when interest rates fall include private equity, venture capital, and real-estate investments like REITs. Basically, these are assets that thrive on cheap cash—the lower the interest rates, the easier it is for a company to invest in itself and for construction companies to build apartment buildings that customers will buy with a low-interest loan.

On the other hand, alternative assets like art and antiquities are uncorrelated to interest rates—whatever someone is prepared to pay for a classical painting is what the painting will be worth. Moreover, commodities like precious metals are fairly uncorrelated with interest rates and the stock market as a whole—their price depends on supply and demand and most of them are so crucial that the economy can’t work without them.

Let’s take nickel as an example. This semiconductor saw a huge spike in demand due to the Russia-Ukraine conflict in 2022 which led investors to assume that Russia’s supply of nickel will stop flowing westward. And in today’s world, the nickel must flow.

Visual chart of the price jump of nickel in early 2022
The jump in the price of nickel in early 2022 was entirely caused by geopolitical events and was not significantly correlated with interest rate changes. Image by TradingView.

This sudden price spike caused some trouble for the tech industry but the EV industry took an especially big hit because of its heavy reliance on the metal. All in all, diversifying a portfolio with alternative assets can make it resistant to the effect of interest rates, but these assets require as much research, regular rebalancing, and attention as stocks.

Expectations Can Have an Impact 🌠

If a tree falls in a forest but nobody hears it, did it really fall? We can apply a similar question to what happens if the FED changes interest rates and no one hears about it (through some miracle)? Does that mean that the markets will not change their behavior? Well, maybe.

What is really going on is just one piece of the puzzle—but how investors react to this is what really moves the markets. So, if you know what the sentiment of the markets is, you have a much better chance of predicting what will happen when news of new interest rates drops—it is possible for investors to trade the news if they are in the loop and are quick enough.

As we’ve discussed, interest rate changes don’t always bear the same results—a lot depends on the current economic situation, and interest rates themselves don’t determine everything. But, if the media hypes investors up and prepares them for a specific scenario—like “rates will go up and stocks will go down”—we can expect a significant reaction from the markets.

This was always the case, and with more than just interest rates—for instance, the news about the Suez canal blockage in 2021 led to a jump in commodity prices world-around. So, before investors try to predict the consequences of the next FED decision, they should take mass mentality into account and watch the news to get a feel for what other investors might be thinking.

Conclusion 🏁

It sure is boring to read about interest rates every day in financial news, but unfortunately, as boring as they are, they’re also important. Most stocks are significantly impacted by interest rates whereas bond prices are even more of a slave to interest rates.

However, many assets are not correlated to interest rates, so it is not very difficult to decouple a portfolio from the FED’s enlightened whims. All in all, there is always a way to profit off of interest rates, so more than anything, each rate change should be viewed as an opportunity to make small, but positive changes to your investment portfolio.

The Relationship Between Interest Rates and Stocks: FAQs

  • What is the Key Rate?

    The key rate is the rate at which banks can borrow from other commercial banks or the Federal Reserve if they are lacking in required cash reserves. The key rate is set by the FED but it is made so that it is always cheaper for banks to borrow from other banks—the so-called discount rate determines the cost of borrowing from the FED, whereas the federal funds rate determines the rate at which banks can borrow from other banks.

  • What is a Zero-Bound Interest Rate?

    A zero-bound interest rate is a short-term monetary policy that insures 0% borrowing interest rates for banks and other such financial entities. The idea behind this policy is that giving away what is essentially free money will stimulate the economy and the market via an injection of borrowed capital.

  • Why Are High Interest Rates Bad for Growth Stocks?

    As a rule of thumb, higher interest rates can destabilize the whole stock market by increasing the price of debt institutions use to buy stocks. However, some stocks are more sensitive to this than others—growth stocks that rely heavily on the momentum of their share price and on debt to keep the company running usually get hit much harder by interest rate increases.

  • What Happens to Interest Rates When the Stock Market Crashes?

    Generally, a stock market crash can indicate that the economy is failing, as was the case when the COVID-19 pandemic caused a huge part of the economy—and especially airlines—to grind to a halt. In this case, the government usually lowers interest rates to revive the economy. However, if the crash is caused by a bubble, investors can lose faith in the market despite the lowered interest rates, as was the case in 1990s Japan.

  • What Happens to Inflation When Interest Rates Rise?

    In theory, interest rates and inflation should have an inverse relationship—when rates are high, inflation is lower and vice-versa. However, whereas interest rates depend on the decisions of centralized institutions, the rate of inflation is determined by countless economic factors, so a mere change in interest rates might not have a strong effect depending on the situation.

  • What Are the 4 Factors That Influence Interest Rates?

    The interest rates determine the price of borrowing and are driven by supply and demand in the market. Other than supply and demand, each loan is priced based on 4 main factors: time of loan, credit risk, convertibility, and tax burdens.

  • Do Interest Rates Follow the Stock Market?

    In many cases, the lowering of interest rates will stimulate the market and an interest rate increase will destimulate it. However, the empirical evidence of more than a century of stock market activity tells us that this is by no means always the case—there have been situations where stock prices followed increasing interest rates and vice-versa. 

  • How Are Interest Rates Related to Stocks?

    Stocks can be bought using borrowed cash which is more available when interest rates are low—this is usually done by financial institutions and banks. Also, lower interest rates lead to higher inflation and generally, to higher stock prices, so the markets usually view interest rate cuts as a signal to buy, and a rate increase as a bearish sign.

  • What Makes Interest Rates Go Up?

    If the demand for loans is low (due to a slowing economy and stock market that doesn’t seem worth investing in) and lenders believe that the risk of credit is high, that will lead to higher interest rates. Central banks might have other considerations when determining interest rates like what impact the changes will have on the future of the economy.

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