Skip to content 
Stock market performance is much affected by interest rate changes. Not only stock performance, but also the performance of gold, bonds, and currency takes a hit, which ultimately affects your investment returns.
Understanding the relationship between interest rates and stock prices is important to get better investment returns. Because, the market reaction to interest rates change can be extreme. This article aims to explore how interest rates affect stock market performance and how to benefit from it. Let’s start.
What Are Interest Rates?
Interest rates refer to the cost of borrowing money. In the US, the Federal Reserve controls the interest rates as per the monetary policy. Any change in the Fed rate influences interest rates on loans, mortgages, savings accounts, and even corporate bonds.
Through interest rate changes, the Federal Reserve signals its outlook on inflation, growth, and the health of the economy.
Why are Interest Rates Important?
Interest rates are the foundational element of the financial system. It influences how businesses and individuals borrow or save money. Understanding the ripple effects of changes in US interest rates is essential. Here’s a breakdown of why interest rates matter:
Cost of Borrowing for Companies: Rising interest rates push the cost of borrowing for companies, leading to higher operational costs. This leads to lower profits, particularly for companies that rely heavily on debt. Like the real estate, utilities, and capital-intensive industries. The opposite happens when the interest rate falls.
For example, in 2020, when the Fed cut rates to near zero, corporations started reporting a surge in profit margins. Non-financial corporate profit margins increased to about 19% in Q12022, compared to about 13% in Q42019.
Consumer Spending and Demand: Higher interest rates increased borrowing costs, thus reducing discretionary spending, affecting companies in retail, travel, entertainment, and luxury.
When economic growth declines, the central bank reduces rates to encourage consumers to spend more, often leading to stronger revenue growth.
Stock Valuations: Rates directly affect the future earnings of the company, resulting in how stocks are valued today. We have discussed the relationship between interest rates and stock prices in greater detail in the next section.
Currency Strength and Global Capital Flow: Differences in interest rates between two countries affect currency valuations and capital flows. As US bond yields rise, equities become less attractive. Investors can now earn higher risk-free returns on their investments. It results in capital flowing out from emerging countries to the US, resulting in a stronger dollar.
Relationship Between Interest Rates and Stock Prices
Stock market and interest rates are correlated. The general rule of thumb is that interest rates have a direct and inverse impact on stock valuations. It means, when interest rates are lower, stock valuations could rise, and when interest rates rise, stock valuations drop.
This happens because the value of any stock depends on the present value of all future cash flows. This includes earnings, dividends, and share buybacks.
Let’s simplify this part.
The price of any stock is based on how much future profit it will return to shareholders, adjusted for today’s value, which we also call present value.
So, the formulae to derive the stock price is:
Stock Price = Future Earning, Dividends, Buybacks(1+ Discount Rate)t
The numerator is the cash the company will give you in the future.
The denominator is the discount rate, reflecting the interest rate and risk.
When the interest rate rises, the denominator gets bigger, reducing the stock’s present value and causing a fall in stock price. Let’s understand this with an example.
Before Interest Rate Hikes
You are analysing X stock, expecting to return $10 annually for the next five years via earnings.
Assuming the interest rate (discount rate) is 2%.
Present Value = 10(1.02)1+ 10(1.02)2+…+ 10(1.02)5 = 9.80 + 9.61 + 9.42 + 9.24 + 9.06 = 47.13
So, the present value of X stock with these discounted cash flows is $47.13.
After Interest Rate Hikes
The Fed has hiked interest rates to 5% in multiple increases, so the discount rate will be 5%.
Present Value = 10(1.05)1+ 10(1.05)2+…+ 10(1.05)5 = 9.52 + 9.07 + 8.64 + 8.23 + 7.84 = 43.30
After the rate hike, the cash flows are worth less today, therefore, the stock price will adjust and drop to $43.30, although there is no change in earnings.
Do stocks go down when interest rates rise?
Yes, stock prices do go down when interest rate rises because of the discounted cash flow effects.
In December 2021, the Federal Reserve started hiking interest rates to control the runaway inflationary condition. The interest rates were increased from 0.25% to 5.5% in late 2023. One of the steepest rate hikes ever recorded.
This resulted in a massive drop in stock prices in the US as the higher discount rates reduced the present value of future earnings. In 2022, the S&P 500 index closed 18.11% lower, despite the index reporting growth in earnings. While, Nasdaq 100 closed the year 32% lower.
What stocks will benefit from lower interest rates?
Lower interest rates benefit the entire economy, as corporations and individuals can borrow at lower rates. Supporting growth and risk-on investing.
Technology stocks get higher valuations as future earnings are more valuable at low discount rates. Real estate and utility companies benefit from cheaper capital and stable cash flows.
And, the consumer discretionary space gets a boost from stronger spending.
In 2020, when central banks around the world lowered interest rates, stock prices got a boost due to lower discount rates. Market reaction to interest rate change was swift and pronounced. Nasdaq 100 in 2020 and 2021 returned 48% and 27.5%, respectively.
Conclusion
Interest rates are one of the powerful forces in the stock market. It affects stock valuations, future profits, and capital flows. Therefore, you need to watch the Fed’s rate decisions, FOMC commentary, and monitor the US Dollar index (DXY) for capital flow trends.
During rare change cycles, stock market volatility tends to rise. Therefore, to reduce the interest rate risk on your portfolio, diversify into sectors that perform well across cycles.
