The symbiotic relationship between interest rates & stock markets

Stock markets around the globe continue to drop as hesitancy surrounding interest rates continues to grow amid inflation and tighter consumer spending.

It’s the conversation that is occurring around the world, the two words that linger and cause major shifts in the finances of households across every country – interest rates. Interest rates have an interesting way on a variety of industries as the percentage directly correlates with the spending and borrowing power of major institutions.

While it typically takes some time for interest rate changes to effectively impact the economy and ripple through to households, the stock markets are usually the first responders when these changes are implemented, the markets act as the canaries in the coalmine. It makes sense, consumer spending and disposable income often correlate with market valuations and bottom lines with a higher interest rate often leading to lower value.

So, why is this symbiotic relationship between interest rates and stock markets around the world an effective gauge of the future?

Read on to find out.

Describing interest rates

The symbiotic relationship between interest rates & stock markets

Let’s get a definition out of the way as we will be referring to interest rate and stock markets a lot in this article. The interest rate is essentially the associated borrowing costs for banking institutions to borrow money from the federal reserve, expressed as a percentage.

The higher the rate, the more expensive it is for banks to borrow money which has a logical dripping effect, as banks will then charge a higher interest rate for their consumers to borrow money. A lower interest rate will have the opposite effect.

Credit card rates, mortgage repayments, debts accrued, all of these avenues of moneylending are invariably impacted by a change in the interest rate with economic stimulation or restriction being highly dependent on the set rate.

Higher rates

Higher rates

Higher interest rates impact businesses and consumers on two fronts. A higher rate for borrowing means that businesses have higher fees to pay in borrowing money and potential losses in revenue from less consumer spending.

Consumers continue to pay their bills but will likely have less disposable income to stimulate business revenue. As banking institutions will be charged more to borrow money, they in turn will charge their consumers a higher rate for borrowing money (mortgages, credit cards etc.).

Businesses partly derive their value from operating costs and outright revenue capability – a higher interest rate impacts both negatively.

Lower rates

Lower rates

On the flip side, a lower interest rate is indicative of a growth period for the economy whereby consumer spending is more encouraged which positively impacts businesses in general. If the interest rate falls for instance, banking institutions will be paying less to borrow money, consumers will be more confident in borrowing money for larger purchases, and businesses will be able to cut their operating costs.

Correlating the interest rate with stock market prices is becoming a little clearer already, let’s lay our cards on the table.

Interest rates & the stock market

As we mentioned before, it usually takes around 12 months to see the real impact of an interest rate hike or reduction in the economy, however, stock markets are where the impacts manifest much quicker. Businesses that are not growing optimally, either due to less revenue, increased operating costs, or a combination of both – will have lower potential cash flow in the future which invariably impacts the market value.

stock market

If enough companies on the stock exchange begin losing their value, a domino effect could potentially be instigated. With less faith in economic growth, more investors sell their positions before accruing too much of a loss. Looking at any key index, there is a lot of hesitancy, with recent plunges on the DOW Jones and S&P 500 as a correlation of tighter inflation and increasing interest rates.

The looming threat of a recession is also causing rifts in the investment community as overtightened interest rates could have a detrimental effect in pushing the economic system over the edge.

There is one sector of the industry that ironically tends to find potential growth with higher interest rates. The financial sector. Financial institutions like banks and other moneylenders tend to increase their overall profit margins thanks to higher lending rates and borrowing costs from their consumers.

The psychology of it all

Consumers and businesses don’t even need to do anything for interest rates to have an impact on the stock market. The psychology of it all stems from the logical conclusions that are found with an interest rate increase or decrease.

If the interest rate increases for example, both businesses and consumers will reduce their spending and restrict cash flow which will cause a dip in the market. On the other hand, if there is the announcement of an interest rate cut, consumers and businesses will be encouraged to spend more and stimulate the economy further which will be reflected in the share market increasing in value and overall revenue.

The ASX & pinned expectations

For Australian investors, the recent dip that caused a majority of shares to drop in value has not been too encouraging with only 4 reported companies posting a profit in share price on Monday August 29th 2022. The dip seems to be a response to extended interest rate hikes and little chance of a cut for the foreseeable. While this has shaken many investors and everyday Australians around the globe, there is still renewed focus on the silver lining.

For those who have the capital set aside, purchasing share prices at a steal may be enticing. The interest rates seem to be remaining for the time being – stock markets will continue reflecting the outlook for the economy. While there is no direct connection with interest rates and the stock market per se, they tend to work in opposite of one another, while one is up the other comes down. This is not always the case as each interest rate episode will come with its own contexts and caveats, but it is interesting to observe the symbiotic relationship play out.

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