Stocks and Interest Rates

Have you ever wondered why stocks fall whenever the Federal Reserve raises interest rates? Well in today’s article, we are explaining why this happens. For more of a basis in what stocks and interest rates are before reading this article, check out our previous articles!

But first, how and when does the Fed change interest rates? The FOMC, which is a committee of people from the Fed, meets 8 times a year to decide whether to increase, decrease, or keep interest rates constant. When they increase interest rates, the economy typically slows down and there is less activity. This is because interest rates essentially act as the cost to obtain money over time. The higher the cost of money is to consumers and businesses, the less likely it is that they will spend money. Similarly, when the FOMC lowers interest rates, the economy typically speeds up and there is more economic activity.

To illustrate this, imagine you want to buy a new video game console that costs $100. You plan to borrow the $100 from your older sibling and pay them back with interest next month. In this case, would you prefer an interest rate of 5% or 10%?

You would be much more inclined to buy the controller if you only had to pay back $105 as compared to paying $110. This is very similar to how interest rates affect the economy: it affects how much businesses and people borrow. If businesses are borrowing less, they aren’t able to invest in new infrastructure and the estimated amount of future cash flows will drop, thus lowering the stock price. If people are borrowing less, that means less big purchases and economic activity to stimulate the stock market. When interest rates rise, other investment options like bonds that are more valuable when they have high interest rates become attractive.

drop any comments or questions below!