The cost of money: how interest rates affect the market

This article is a private opinion based on private research and should not be considered advice.

The cost of money: how interest rates affect the market
Photo: rawpixel, Pixabay

For the majority of last year, the business world was locked in suspense over a possible interest rate hike from the United States Federal Reserve, colloquially referred to as the Fed. That suspense was finally broken this year in March and then again in June when the interest rate went back to its highest level in a decade. Furthermore, the Fed has announced at least one more hike this year with the details to be decided later on.

Ever since the 2008 financial crisis which likely could have crashed the United States economy if not for the last minute government bailout, interest rates have been kept low as an incentive for recovery. Now that the economy has more or less recovered, interest rates have risen to pre-2008 levels (in the US – Australian interest rates are still at a record lows). As detailed in most trading courses, interest rates have a pretty major impact on the financial market, which will be detailed further below.

The basics of interest rates

If you’ve ever used a credit card before then you should already be familiar with the term interest rates. In layman’s term, interest rate is the amount that is charged to the borrower by the creditor for the use of creditor’s assets, usually expressed in terms of percentage. For example, if you purchase a 4K TV for the price of $500 and a credit card interest rate of 10%, that means you’ll have to pay an extra $50 for using your bank’s money to buy that TV.

When we’re talking the Federal Reserve interest rate, we’re talking about the federal funds rate, or the interest rates at which depository institutions, such as commercial banks, are charged for borrowing money from the Federal Reserve or other countries central banks. Central banks do this to control inflation, by raising interest rates; they’re attempting to reduce the supply of money, thereby making them more expensive while lowering them essentially increases the supply of money. This is why they’re sometimes referred to as the cost of money.

The ripple effect of interest rates

While the federal funds rate only refers to exchanges between banks and the Federal Reserve, this rate is also the number upon which prime interest rates are based on. When a company takes out a loan from a bank for the purpose of business, the prime interest rate is the rate that company is charged on. Mortgage loan rates, the annual percentage rate (APR) for commercial credit cards and other types of loans are all based on that number as well.

I mean, it’s pretty simple when you think about. If it costs banks more to borrow money from the Federal Reserve, it’s only natural for those banks to pass those costs along to the customers. For individuals like you and me, that would manifest as an increase to credit card interest rate and any other loan that might carry a variable interest rate. Even if your credit card bills stay the same, the cost of using that credit card itself increases, which means you’re going to have to spend less on other expenses, which slows down the economy as a whole.

Businesses are also impacted by this as they rely on banks for expansions and a portion of their day-to-day operations. For businesses that rely on projects, banks are essential since the bills are usually footed by the banks, which take into account the potential future cash flow from these projects and/or expansions. With higher interest rates, businesses would be forced to take less projects and make less expansions, which would inevitably slows their growth and sometimes even force them to induce cutbacks.

How rising interest rates affect the stock market

From the explanation above, it’s pretty easy to guess how the stock market could be affected by rising interest rates. Keep in mind that interest rates affect the market as a whole, pretty much every industry is connected to banks and other financial institutions. Less profit and reduced potential of future cash flows would automatically reduce investor’s faith on the company since they’re likely to see less stock appreciation. For the most part, this would lead to an decrease in a company’s stock price.

Due to the wide-ranging impact of interest rates, it’s quite likely that key indexes, such as the United States’ Dow Jones Industrial Average or the Australian ASX, which is what the general public think as the ‘market’ will go down as well. Stock ownership are seen as less desirable immediately following a rate hike but will eventually normalise down the line as long as there are no more rate hikes in the near future.

Of course, as with everything else, there are always exceptions to the rule. To wit, remember that the extra cost is passed along from the Federal Reserve to the banks and finally to both the individual customers and businesses, the banks and other financial institutions don’t actually have to contend with the extra cost. Sure, this would lead to customers borrowing less money but also keep in mind that some expenses are too essential that they can’t be negotiated.

The healthcare industry for example doesn’t really stop for anything, which means that insurance companies are less affected by rate hikes compared to other companies. Banks too compensate for less borrowing by simply charging more for lending and all things being equal shouldn’t be affected much by rate hikes. The financial industry as a whole tends to be your best bet when it comes to performance after a rate hike.