When the Fed increases the federal funds rate, it does not directly affect the stock market itself. The only truly direct effect is that it becomes more expensive for banks to borrow money from the Fed. But, as noted above, increases in the federal funds rate have a ripple effect.
The first ripple: Because it costs them more to borrow money, financial institutions often increase the rates that they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if these loans carry a variable interest rate. This has the effect of decreasing the amount of money consumers can spend. After all, people still have to pay the bills, and when those bills become more expensive, households are left with less disposable income. This means that people will spend less discretionary money, which will affect businesses’ top and bottom lines (that is, revenues and profits).
But businesses are affected in a more direct way as well. They too borrow money from banks to run and expand their operations. When the banks make borrowing more expensive, companies might not borrow as much and will pay higher rates of interest on their loans. Less business spending can slow down the growth of a company; it might curtail expansion plans and new ventures and even induce cutbacks. There might be a decrease in earnings as well – which, for a public company, usually means the stock price takes a hit.
Interest Rates and the Stock Market
So now we see how those ripples can rock the stock market. If a company is seen as cutting back on its growth spending or is making less profit – either through higher debt expenses or less revenue – then the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company’s stock. (A key way to value a company is to take the sum of all the expected future cash flows from that company discounted back to the present. To arrive at a stock’s price, take the sum of the future discounted cash flow and divide it by the number of shares available.)
If enough companies experience declines in their stock prices, the whole market, or the key indexes (like the Dow Jones Industrial Average or the S&P 500) that many people equate with the market, will go down. With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable. Furthermore, investing in equities can be viewed as too risky compared to other investments.
However, some sectors do benefit from interest rate hikes. One sector that tends to benefit the most the financial industry. Banks, brokerages, mortgage companies and insurance companies’ earnings often increase as interest rates move higher, because they can charge more for lending.
Interest Rates and the Bond Market
Interest rates also affect bond prices and the return on both CDs and T-bonds and T-bills. There is an inverse relationship between bond prices and interest rates, meaning that as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. The longer the maturity of the bond, the more it will fluctuate in relation to interest rates. (Learn the basic rules that govern how bonds are priced in Bond Market Pricing Conventions.)
When the Fed raises the federal funds rate, newly offered government securities, such Treasury bills and bonds, are often viewed as the safest investments and will usually experience a corresponding increase in interest rates. In other words, the “risk-free” rate of return goes up, making these investments more desirable. As the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same or becomes lower, investors might feel that stocks have become too risky, and will put their money elsewhere.
One way that governments and businesses raise money is through the sale of bonds. As interest rates move up, the cost of borrowing becomes more expensive. This means that demand for lower-yield bonds will drop, causing their price to drop. As interest rates fall, it becomes easier to borrow money and many companies will issue new bonds to finance new ventures. This will cause the demand for higher-yielding bonds to increase, forcing bond prices higher. Issuers of callable bonds may choose to refinance by calling their existing bonds so they can lock in a lower interest rate.
For income-oriented investors, the Fed’s reducing the federal funds rates means a decreased opportunity to make money from interest. Newly issued Treasuries and annuities won’t pay as much. A decrease in interest rates will prompt investors to move money away from the bond market to the equity market, which then starts to rise with the influx of new capital.
What Happens When Interest Rates Fall?
When the economy is slowing, the Federal Reserve cuts the federal funds rate to stimulate financial activity. A decrease in interest rates by the Fed has the opposite effect to a rate hike. Investors and economists alike view lower interest rates as catalysts for growth – a benefit to personal and corporate borrowing, which in turn leads to greater profits and a robust economy. Consumers will spend more, the lower interest rates encouraging them to feel they can finally afford that new house or send the kids to a private school; businesses will enjoy the ability to finance operations, acquisitions and expansions at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices.
Particular winners of lower federal funds rates are dividend-paying sectors such as utilities and real estate investment trusts (REITs). Additionally, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing.