Defining Interest Rates
The interest rate is a proportion that a capital lender imposes on the borrower's repayment of the debt, often spread out over a certain time. For instance, you will be charged interest on the principal amount of a loan from a bank.
Additionally, it refers to the value that the bank provides customers for keeping their money in their account for a predetermined time period.
Any economy has several "interest rates," and they vary between institutions. However, central banks establish the most significant interest rate, which has an impact on all others.
- The Reserve Bank of Australia (RBA) is responsible for making interest rate changes in Australia. The interest rate charged on unsecured overnight loans between banks, known as the cash rate, is manipulated by the central bank.
- The Federal Funds Rate and the Federal Discount Rate are the two in the US. The rate at which banks borrow money from one another is the first, and the rate at which they borrow money from the Federal Reserve is the second.
When these are increased or decreased, banks charge businesses, homes, and consumers higher or cheaper borrowing costs. In essence, this has an impact on how much cash people have available to spend in the economy.
As a result, adjustments to the cash rate will have a direct impact on some of the other interest rates set by commercial banks, such as the following:
- Lending rate: The interest rate that banks charge customers who wish to borrow money is known as the lending rate.
- Deposit rate: the interest rate charged by commercial banks to account holders who deposit cash.
- Mortgage rate: The rate charged for a mortgage over a given term is known as the mortgage rate.
Why are interest rates adjusted by the central bank?
In order to combat the rise in inflation, central banks adjust interest rates. For instance, the central bank may increase interest rates when inflation is out of control. Since fewer people are spending money, the rate of inflation is slowed by the increase in interest rates.
On the other hand, they reduce the rate to stimulate the economy, encourage expenditure, and foster economic activity.
The impact of a rising interest rate
The cost of short-term borrowing for financial institutions quickly increases when the Federal Reserve takes action to raise the discount rate. Almost all other borrowing costs for businesses and individuals in an economy are impacted by this.
Financial organizations frequently raise the rates they charge their customers to borrow money since it costs them more for them to borrow money. Therefore, rises in credit card and mortgage interest rates have an effect on certain consumers, especially if these loans have a variable interest rate. The amount of money that customers may spend declines as credit card and mortgage interest rates rise.
Bills still need to be paid by consumers. Households have less money available as a result of rising utility costs. Businesses' sales and earnings fall when consumers have less disposable income.
As you can see, as interest rates rise, businesses are affected by rising borrowing costs as well as the negative consequences of waning consumer demand. These two variables may have an impact on earnings and stock prices.
The impact of a falling interest rate
The Federal Reserve lowers the federal funds rate to boost financial activity when the economy is slowing. The Federal Reserve's reduction in interest rates has the opposite impact of a rate increase. Lower interest rates are seen as an advantage for both personal and business borrowing by investors and economists alike. This, therefore, results in higher profits and a healthy economy.
Due to the decreased borrowing rates, consumers will spend more because they believe they may finally be able to afford that new home or send their children to a private school. Businesses will benefit from being able to fund operations, purchases, and expansions at a lower cost, enhancing their potential for future profits. In turn, this causes stock values to rise.
Dividend-paying industries like utilities and real estate investment trusts, in particular, benefit from lower federal funds rates (REITs). Large businesses that have robust balance sheets and consistent cash flows also benefit from more affordable debt borrowing.
The Federal Fund Rate
The federal funds rate is the interest rate that has an effect on the stock market. The discount rate is the interest rate that Federal Reserve Banks charge when they make secured loans to depository institutions, typically overnight, whereas the federal funds rate is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans.
In order to keep inflation under control, the Federal Reserve affects the federal funds rate.
The Federal Reserve is effectively trying to reduce the amount of money available for making purchases by raising the federal funds rate. As a result, getting money becomes more expensive. On the other hand, when the Federal Reserve lowers the federal funds rate, the money supply rises. This makes borrowing less expensive, which increases spending. Similar trends are followed by the central banks of other nations.
The impact of rising fed-interest rates
The Fed boosts interest rates to reduce inflation when it becomes out of control or when asset bubbles become unmanageable.
Increased rates have an impact on the overall economy. Cash flows are slowed by rising interest rates on mortgages, auto loans, and business loans. This may cause companies to alter or postpone their expansion strategies.
Higher interest rates might encourage investors to sell assets and take profits in the stock market, particularly during periods like these where stocks have experienced several years of double-digit percentage returns. As you might expect, investor moves like this have the potential to reduce stock prices—if not across the board, then at least individually.
Additionally, if interest rates increase high enough, cautious investors may start to find monotonous savings products like certificates of deposit (CDs) or high-yield savings accounts more alluring.
What happens to the stock market when interest rates rise?
The thing about interest rate increases and the American stock market is this. You can be let down if you look for data that demonstrates a connection between higher rates and declining markets.
In order to determine what the past has to say about stock market performance during these periods, Dow Jones Market Data has reviewed the five most recent rate hike cycles. Their data, which is shown in the graph below, shows that across these five lengthy periods, just one rate hike cycle saw a decrease in the three major stock market indices.
| Rate Hike Cycle | DJIA | S&P 500 | Nasdaq |
| Feb. 1994 to July 1995 | 16.30% | 13.80% | 18.10% |
| March 1997 to Sept. 1998 | 17.40% | 32.60% | 40.00% |
| June 1999 to Jan. 2001 | -1.60% | -5.00% | -13.30% |
| June 2004 to Sept. 2007 | 28.70% | 30.00% | 26.90% |
| Dec. 2008 to July 2019 | 213.70% | 243.10% | 442.00% |
| Average % Change | 54.90% | 62.90% | 102.70% |
| Median % Change | 17.40% | 30.00% | 26.90% |
When all five cycles were taken into account, the S&P 500 experienced a median gain of 30%, compared to a median gain of approximately 27% for the Nasdaq and a median gain of 17.4% for the Dow Jones Industrial Average (DJIA).
For instance, the federal funds rate rose steadily from 1.0% to 5.25% between June 29, 2004, and September 17, 2007, while the DJIA increased by 28.7%.
The notion that higher rates cause stocks to decline can be refuted by evidence that isn't all that old. The S&P 500 increased by more than 18% in 2017 despite the Fed raising interest rates three times.
The short-term impact on the stock market of rising interest rates
Is this image different in the immediate future? When the Fed announces something, do investors quickly flee, but things eventually turn around? We've all witnessed dramatic reporters anxiously announcing Fed meeting outcomes over choppy phone lines as market statistics plummet.
Looking at the S&P 500's performance over the nine rate hikes by the Fed between December 2015 and December 2018 reveals a murky picture.
| Date | % Increase | S&P 500 1-Day Return | S&P 500 1-Month Return |
| 16 Dec. 2015 | 0% | -0.7% | -9.3% |
| 14 Dec. 2016 | 0% | +0.4% | +0.9% |
| 3/15/2017 | 0% | +0.7% | -2.3% |
| 6/14/2017 | 0% | -0.3% | +1.4% |
| 12/13/2017 | 0% | -0.5% | +4.6% |
| 3/21/2018 | 0% | +0.7% | +3.8% |
| 6/13/2018 | 0% | -0.9% | -5.4% |
| 9/26/2018 | 0% | +0.1% | -8.5% |
| 12/19/2018 | 0% | -3.1% | +6.6% |
| Average % Change | -0.4% | -0.9% | |
| Median % Change | -0.3% | +0.9% |
The S&P 500 fell 0.5% the day after the Fed raised interest rates on December 13, 2017, but rose 4.6% a month later. However, the benchmark index only slightly increased the next day after the rate hike on September 26, 2018, and it dropped 8.5% after one month.
In contrast to the long-term pattern presented above, the short-term market movements following Fed rate hikes show a very varied bag of outcomes. That offers day traders little solace. However, the message is very obvious for buy-and-hold stock market investors with a longer time horizon: Fed rate hikes aren't necessarily a bad thing.
The relationship between stock performance and rising rates
It's critical to remember that not everyone is negatively impacted by rate increases when attempting to predict which direction the market may move. In reality, they can benefit some industries, such as financial stocks. Bigger interest rates translate into higher margins if you are in the loan sector.
On the other side, growth equities, such as tech companies, typically suffer from higher rates. Investors frequently seek out reliable businesses during times of market uncertainty, such as commodities, Dow Jones mainstays, or even older, more reputable IT companies.
These businesses frequently pay dividends, ensuring some growth even if the share price declines. High borrowing costs can seriously limit the growth of high-growing companies because they frequently invest their cash in business expansion and frequently burn through it.
Due to their propensity to correctly predict which businesses and sectors to invest in when market conditions change, selective investors, sometimes known as "stock pickers," may benefit from challenging economic conditions.
But even for experts, it can be challenging to time events correctly because you must take into account not only the Fed's decisions but also those of other investors, many of whom have already factored rate increases into their trading strategies.
Therefore, you're probably too late for that chess move if you think you should trade based on the anticipated hike that will be revealed at the Fed meeting on February 15–16.
Take heart, though, investors. While the Fed's overnight lending rate is significant, stock market returns are influenced by a variety of factors.
That explains in large part why experts advise the majority of consumers to invest in diverse portfolios of big index funds. This way, no matter what happens, you already have exposure to short-term winners (even if it means holding some losers as well). And that puts you in a position to succeed over the long term.
The relationship between interest, stocks, and bonds
Bond prices and interest rates have an antagonistic connection. In other words, bond prices decline as interest rates rise and vice versa. This is due to the fact that when all other rates change, a bond's price must adjust in order to be competitive and appealing to investors.
For illustration, suppose you had a bond worth $1000 that pays a fixed $50 coupon, or 5% interest.
Given that the coupon remains fixed at $50 when other rates rise above that, let's say to 5.26%, the bond price will have to drop to $950 in order to offer the same interest rate (5.26%) and remain competitive. [$50/ $950 x100 = 5.26%]
Bond demand will often increase if interest rates fall below the coupon rate since it is a better investment. The bond's price rises in tandem with the level of demand.
On the other hand, if interest rates increase beyond the bond's coupon rate, demand would decline and the bond's price will increase.
Due to the fact that bonds traditionally have lower risk than stocks but now offer larger rewards as a result of rising interest rates, investors are switching from equities to bonds as a result of this new risk-reward profile. The inverse is also accurate.
Where can you stand with interest rates?
Leveraged derivatives, such as CFDs, can be used to make short-term predictions about interest rate trends. To protect against other assets, such as mortgage repayments, that can be impacted by fluctuations in interest rates, you can go long or short.
Start by performing the following actions:
- Do some market research.
- Choose between trading and investing.
- Open a profile or test out a free demo.
- Choose an opportunity.
- Set the size of your position and control your risk.
- Put your trade-in and keep an eye on your position.
There are numerous methods to take a position on the effects of interest rate announcements, and you have access to more than 18,000 marketplaces. These methods of exposure are available to you:
Equity trading
To open an account with us and begin trading shares, follow these steps:
- Purchasing and selling of company and ETF shares
- Purchasing and selling bonds ETFs shares
Trading with CFDs
Establish a CFD trading account to:
- Instead of holding any actual stocks, use derivatives to speculate on share and ETF prices.
- Trade on the yields of the most popular government bonds
- Go long or short on index futures or options pricing for the stock market.
- Utilize our unique inflation indexes to trade on inflation.
The final verdict
Although there is a pretty indirect relationship between interest rates and the stock market, the two often move in different ways. As a general rule, the stock market rises when the Federal Reserve lowers interest rates; the stock market declines when the Federal Reserve raises interest rates. However, there is no assurance as to how the market will respond to any particular adjustment in interest rates.
FAQ
When interest rates rise, what stocks also rise?
The Federal Reserve raises interest rates in an effort to slow down an expanding economy. Certain industries, such as those that don't depend on economic growth, including the consumer goods, lifestyle necessities, and industrial goods sectors, may be well-positioned for the future by making credit more expensive and difficult to obtain. Additionally, since they do not need expensive outside finance for expansion, businesses that do not rely on low-cost debt for growth can experience an increase in interest rates.
What is the impact on growth stock when interest rates rise?
Growth stocks rely primarily on money for potential future corporate growth. Growth stocks thrive during times of low-interest rates since capital can be acquired at a low cost and growth is easier to come by. Therefore, many investors think that growth stocks become less attractive as interest rates rise since their capacity to secure low-cost debt financing is more challenging and their long-term discounted cash flow is lowered.
What should you invest in when interest rates rise?
There is no one optimal investment that is good for all investing conditions because all macroeconomic situations differ. However, when interest rates are rising, some asset types do tend to do better. Shorter-term bonds are frequently preferred since long-term rates carry higher risk. You might think about government bonds designed specifically for inflation if higher rates are a result of inflation. Last but not least, you can think about shorting the stock market if you think that rising interest rates will harm the value of stocks. Consult your financial advisor for advice on direct investments.
What is the new interest rate?
The average 30-year fixed-mortgage rate is currently 6.89% as of Thursday, October 6, 2022, up 7 basis points from the previous week at the same time. If you're looking to refinance your mortgage, the 30-year national average refinance rate is 6.89% today, up 6 basis points from last week at this time.
Which stocks perform well with rising interest rates?
4 financial stocks to buy as interest rates rise:
- Bank of America Corp. (BAC)
- Morgan Stanley (MS)
- Charles Schwab Corp. (SCHW)
- American Express Co. (AXP)