How Interest Rates Affect the U.S. Markets

Changes in interest rates can have both positive and negative effects on the markets. Central banks often change their target interest rates in response to economic activity: raising rates when the economy is overly strong and lowering rates when the economy is sluggish.

In the U.S., the Federal Reserve Board (the Fed) is responsible for setting the target interest rate at which banks borrow and lend money to one another (known as the federal funds rate), and this has a ripple effect across the entire economy. While it usually takes at least 12 months for a change in this interest rate to have a widespread economic impact, the stock market's response to a change is often more immediate.

In addition to the federal funds rate, the Federal Reserve also sets the discount rate; or the interest rate the Fed itself charges banks that borrow from it directly. This rate tends to be higher than the target federal funds rate (in part, to encourage banks to borrow from other
banks at the lower federal funds rate).

Understanding the relationship between interest rates and the stock market can help investors understand how changes may impact their investments. They can also be better prepared to make better financial decisions. Below, we will examine how interest rates can have an effect on the economy as a whole, the stock and bond markets, inflation, and recessions.

The Fed Funds Rate

The interest rate that impacts the stock market is the federal funds rate. The federal funds rate is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans (whereas the discount rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans—usually overnight—to depository institutions).

The Federal Reserve influences the federal funds rate in order to control inflation. By increasing the federal funds rate, the Federal Reserve is effectively attempting to shrink the supply of money available for making purchases.

This, in turn, makes money more expensive to obtain. Conversely, when the Federal Reserve decreases the federal funds rate, it increases the money supply. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns.

How Interest Rates Affect Spending

With every loan, there is some probability that the borrower will not repay the money. To compensate lenders for that risk, there must be a reward: interest. Interest is the amount of money that lenders earn when they make a loan that the borrower repays, and the interest rate is the percentage of the loan amount that the lender charges to lend money.

The existence of interest allows borrowers to spend money immediately, instead of waiting to save the money to make a purchase. The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses or cars.

When consumers pay less in interest, this gives them more money to spend, which can create a ripple effect of increased spending throughout the economy. Businesses and farmers also benefit from lower interest rates, as it encourages them to make large equipment purchases due to the low cost of borrowing. This creates a situation where output and productivity increase.

Conversely, higher interest rates mean that consumers don't have as much disposable income and must cut back on spending. When higher interest rates are coupled with increased lending standards, banks make fewer loans.

This affects not only consumers but also businesses and farmers, who cut back on spending on new equipment, thus slowing productivity or reducing the number of employees. The tighter lending standards also mean that consumers will cut back on spending, and this will affect many businesses' bottom lines.

When comparing the average dividend yield on a blue-chip stock to the interest rate on a certificate of deposit (CD) or the yield on a U.S. Treasury bond (T-bonds), investors will often choose the option that provides the highest rate of return. The current federal funds rate tends to determine how investors will invest their money, as the returns on both CDs and T-bonds are affected by this rate.

The Effect of Interest Rates on Inflation and Recessions

Whenever interest rates are rising or falling, you commonly hear about the federal funds rate. This is the rate that banks use to lend each other money. It can change daily, and because this rate's movement affects all other loan rates, it is used as an indicator to show whether interest rates are rising or falling.

These changes can affect both inflation and recessions. Inflation refers to the rise in the price of goods and services over time. It is the result of a strong and healthy economy; however, if inflation is left unchecked, it can lead to a significant loss of purchasing power.

To help keep inflation manageable, the Fed watches inflation indicators such as the Consumer Price Index (CPI) and the Producer Price Index (PPI). When these indicators start to rise more than 2% to 3% a year, the Fed will raise the federal funds rate to keep the rising prices under control.

Because higher interest rates mean higher borrowing costs, people will eventually start spending less. The demand for goods and services will then drop, which will cause inflation to fall. 

A good example of this occurred between 1980 and 1981. Inflation was at 14% and the Fed raised interest rates to 19%. This caused a severe recession, but it did put an end to the spiraling inflation that the country was seeing.

Similarly, to combat the rising inflation in 2022, the Fed has been increasing rates throughout the year.

Conversely, falling interest rates can cause recessions to end. When the Fed lowers the federal funds rate, borrowing money becomes cheaper; this entices people to start spending again.

A good example of this occurred in 2002 when the Fed cut the federal funds rate to 1.25%. This greatly contributed to the economy's 2003 recovery. By raising and lowering the federal funds rate, the Fed can prevent runaway inflation and lessen the severity of recessions.

How Interest Rates Affect the U.S. Stock and Bond Markets

Stocks

When interest rates rise, it also makes it more expensive for companies to raise capital. They will have to pay higher interest rates on the bonds they issue, for example. Making it more costly to raise capital could put a damper on future growth prospects as well as near-term earnings. The result could be a revision downward in profit expectations going forward as rates increase.

If a company is seen as cutting back on its growth or is less profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company's stock.

If enough companies experience declines in their stock prices, the whole market, or the key indexes many people equate with the market—the Dow Jones Industrial Average, S&P 500, etc.—will go down. With a lowered expectation in the growth and future cash flows of a company, investors will not get as much growth from stock price appreciation. This can make stock ownership less desirable. Furthermore, investing in equities can be viewed as too risky when compared to other investments.

However, some sectors stand to benefit from interest rate hikes. One sector that tends to benefit the most is 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.

Bonds

Interest rates also affect bond prices. 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 reason for this is actually quite straightforward. Say a bond with a $1,000 face value pays 5% interest annually ($50 per year) at a fixed interest rate. It is issued when prevailing interest rates are also 5%. Say that a year later, interest rates rise to 10%. A bond investor could now buy a new bond for $1,000 and be paid $100 per year for holding it.

This means that the old bond, which pays only $50 per year, has to be worth less; so the only way somebody would buy the 5% bond would be at a discount in the market. Now say interest rates instead fall to 1%. A new bond purchased for $1,000 would only pay $10 per year to bondholders. The old one that pays $50 is now very attractive, and the market will bid this up so that it trades at a premium in the market.

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 expansion. 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, a reduction in the federal funds rate 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 from the bond market to the equity market. The influx of new capital instead can cause the equity markets to rise. 

The Effect of Expectations

Rising or falling interest rates also affect consumer and business psychology. When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

But, nothing has to actually happen to consumers or companies for the stock market to react to perceived interest-rate changes. Even before the Federal Reserve announces a hike, both businesses and consumers may pre-empt this potentiality and cut back on spending.

This can cause earnings to fall and stock prices to drop, and the market may tumble in anticipation. On the other hand, if people expect that the Federal Reserve will instead announce a rate cut, the assumption is consumers and businesses will increase spending and investment. This can cause stock prices to rise.

However, if expectations differ significantly from the Federal Reserve's actions, the market may overreact. For example, suppose that the Federal Reserve is expected to cut interest rates by 50 basis points at its next meeting, but they instead announce a drop of only 25 basis points. The news may actually cause stocks to decline because the assumption of a cut of 50 basis points had already been priced into the market. 

The Bottom Line

Interest rates influence stocks, bond interest rates, consumer and business spending, inflation, and recessions. However, there is often a lag in the timing between an interest rate change and its effect on the economy. Some sectors may react quickly, such as the stock market, while the effect on other sectors such as mortgages and auto loans can take longer to be felt.

By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow investors to understand the big picture and make better investment decisions.

Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as to how the market will react to any given interest rate change.