Interest Rate And Stock Market: How Do The Two Work Together?

The stock market is a platform where a company’s stocks or shares are bought and sold. The market provides the capital companies use to expand their business or production activities. While the interest rate refers to the price, you pay to borrow money. It could also refer to the payment you receive when you lend money to another person. Note that interest rates play a vital role in the economy. It influences how people borrow and what they spend money on at any given period.

But interest rates and stock markets prices are related in a unique way. When the rate is low, stock prices increase. But when the interest rate is high, stock prices plummet. Note that people borrow money to invest. Thus when the rate is high, there is limited borrowing and investments.

Recently, interest rates have dominated the news as many countries grapple with inflation-which has resulted in hikes in the prices of essential commodities. Therefore many central banks have resorted to adjusting the base rate to nip inflation in the bud. Also, we have seen stock prices tumble. So does interest rate affect stock prices? Read on to see how the interest rate and stock market relate.

Why Do Interest Rates Change?

Interest rates play a critical role in the economy and affect our day-to-day lives. So whether it is the interest you earn on savings or interest paid on loans and credit, it directly affects livelihood. But the interest rate banks charge takes a cue from the base rate set by a country’s central bank. In the US, the Federal Reserve sets and adjusts the base rate while the Bank of England does it for the UK. In the eurozone, it is the European Central Bank that sets the base rate.

The government, through the central bank, adjusts Interest rates to control economic activities. During inflationary periods, it increases the rate to discourage borrowing. When it increases the rate, it is able to mop up excess liquidity in the market. During deflationary periods, the central bank lowers interest rates to encourage people and investors to borrow more. When they do so, it increases the amount of money in circulation and spurs economic activities.

How Do Interest Rates And The Stock Market Work Together?

Interest rates and stocks also relate in a unique way. When the rates are high, the price of stocks fall, but when the rates are low, the prices increase.

A high-interest rate increases debt expense and lowers the cash flow. As a result, the company looks less profitable and it impacts the price of stocks negatively. Generally, a high-interest rate diminishes growth expectations and future cash flows. So, investors don’t expect much from stock investment. It discourages them from investing more in stocks and pulls stock prices down.

What Happens To Stocks As Interest Rises Or Falls?

Rising interest rates reduce borrowing and limit the amount of money available for investment. The effect is to push stock prices down. On the other hand, falling interest rates encourage the public to borrow more. It increases the amount of money available for investment. Some of the funds end up in the stock market and push the prices of stocks high.

Also, people may choose to invest in stocks, real assets, or other assets. Such investments stir the economy, boost job creation and improve wages. Thus, high-interest rates discourage borrowing and investment. It slows down the economy while low-interest rates boost growth.

Conclusion

Low-interest rate increases consumption and promotes economic growth. It puts more money in the hands of investors whose demand for stocks increases. But when the demand for stocks exceeds the supply, it pushes the prices of stocks up. On the contrary, when interest rates are high, individuals and businesses spend less. It restricts borrowing and starves the stock market from cash. It pulls down the prices of stocks. Also, high-interest rate is an incentive that encourages people to keep their money in banks so as to earn interest. It starves the stock market of cash and makes the stock prices plummet.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes