Ever wonder why does the stock market place an importance on any interest rate adjustment? Today’s write-up will deal with the effects of interest rate on the stock market.
What is interest rate
When a lender lends money to a borrower, the lender expects some form of payment, from the borrower. That form of payment is interest. The rate of interest is therefore the cost of borrowing money.
When interest rate is high, the cost of borrowing would increase, and vice versa.
Importance of interest rate
Interest rate affects every facet of our lives, to the extent that, monetary policymakers and central banks often adjusts interest rate to steer the growth of an economy.
When economic growth is lacklustre, interest rate could be lowered to spur growth. A low interest rate climate encourages consumers, investors and businesses to borrow. The spur of cheap credit would encourage consumers, investors and businesses, big and small, to increase spending on purchases. These purchases may encompass various assets including, real property, commodities and stocks. This inevitably means consumers, investors and businesses will take up more debt, sometimes more than they can afford (unfortunately). For example, consumers would be more inclined to purchase big ticket items, like houses and cars, when interest on the loans are low. This scenario is a normality in Japan where housing loans can be lower than 1% per annum.
On the other hand, higher interest rate would increase the cost of borrowing for consumers, investors and businesses, and would tend to deter people from borrowing and thus spending, because they would not be able to afford a higher cost of borrowing. As a result, economic growth moderates. More often than not, interest rate is increased to prevent an economy from overheating, or to decrease inflation.
So how does interest rate indirectly affect the stock market? To answer that, you must draw a relationship between interest rate and spending.
When interest rate increases, consumers and investors would have less money to spend than before. As a result, consumers and investors, already saddled with debt, would have to set aside more money towards the repayment of their loans. That leaves borrowers with less disposable income to spend on their needs and wants. Therefore, consumers and investors would buy less goods and services and the companies, which provide goods and services, make less money. When profits shrinks, the price of a listed company’s stocks would inevitably dip, and that causes a drag on the stock market.
In comparison, the stock market tends to perform better in low interest rate environment.
Companies which are already borrowing money from financial institutions would also have to bear the brunt from an increased cost of borrowing as a result of an interest rate hike. Companies would have to pay more to service their debts, leaving less money, as profits.
When interest rate is hiked, investors, who invest in the stock market on credit (margin), would soon find themselves having to close their positions, as any potential profits are offset by higher cost of borrowing. Hence, the stock market is subjected to selling pressures which would usher a slump in the market.
Any adjustment in interest rates, especially by the Feds, may have an impact on your equity portfolio. Being able to discern how the market would react to interest rate adjustments may give you an advantage, to either enter or exit the market. However, if you are investing in the long run, pay very little heed to any adjustments of interest rate.
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