Interest Rates and Stock Market Relationship Explained in Simple Terms

Written by K T

On May 20, 2020
interest rates stock market

What is the Relationship Between Interest Rates And Stock Prices?

How do interest rates affect the performance of stocks and other assets? Are Rising Interest Rates Bad For Equities and Falling Interest Rates are Good?

There are two fundamental beliefs about Interest Rates and Stock Market Relationship

The first says that stocks are less attractive in times of rising interest rates. This happens because companies have higher borrowing costs. Thus they have to pay higher interest on their debts, which reduces the profits. Besides, bonds will become more attractive as a more robust alternative to stocks if interest rates rise. So there is a portfolio shift from shares to bonds after interest rate increases. Opposite is true for falling rates.

But there is also an argument in Interest Rates Stock Market Relationship that shares can be a sensible investment key interest rates rise versus fall.  It is because the central banks raise key interest rates when inflation is rather high and the economy goes well. If the economy is doing well, corporate profits are usually growing. Note: it is not a causality between rising interest rates and higher profits (the opposite is true, see above)! But a simultaneity: the central bank usually raises interest rates when the economy is running smoothly. The latter should have a positive impact on companies and the stock market. Which of the different effects predominates may well differ from company to company and from branch to branch.

Relationship Between Interest Rates And Stock Prices

So we divided the market development into two different phases.  
  1. A “hike phase” – begins after the central bank has raised the base rate for the first time and continues until the base rate lowered again for the first time. 
  2. A “cut phase” begins after the central bank has lowered the base rate for the first time and continues until the day after the base rate raised again. 

This definition has the advantage that the market is always in one of the two phases, i.e. either a rate hike or cut phase. Since the phases also end AFTER the first increase or decrease, it assessed in real-time. Not only afterward, in which phase the market is. The US is in a rate cut phase (because the last change in base rate was a decrease). The Eurozone is in a rate cut phase (because the last change was a cut).

 

How do interest rates affect stocks and bonds

Equity markets in both the United States and the United Kingdom perform better in rate cut phases than in rate hike phases. In the United States, government bonds also perform better in cut phases than during the hikes, while there was no difference in bonds in the UK. In currency, pounds, and dollars even reacted to changes in interest rates. Rate cuts were severe for the dollar but good for the pound, and rate hikes were good for the dollar and bad for the pound.  

The equity markets have a positive inflation-adjusted performance even in periods of rate hikes. This is significantly weaker than in periods of rate cuts yet. In the UK, stocks are even worse off than government bonds when rates are rising 

Not all industries react equally to changes in interest rates. Cyclical sectors such as retail and wholesale and durable consumer goods react negatively to interest rate hikes. Defensive sectors such as healthcare stocks and utilities can benefit. 

Summary: Equity Markets grow significantly weaker during higher interest rates. Stocks from defensive industries such as Healthcare, Energy,  Utilities perform better, in periods of rate hikes. Understanding of that is what will make you a successful trader

Good luck with your trading! Check out our News Scraper Platform.

how do interest rates affect stocks and bonds

 

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