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How Interest Rates Affect the Stock Market

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Interest rates: they affect nearly every aspect of our lives.

Whether we’re buying a house, or paying off credit cards, we need to keep an eye on interest rates to make sure our money goes as far as it can.

But interest rates can affect the stock market, too.

Even if you haven’t invested in any stocks, the link between interest rates and the stock market can impact your life.

Read on to find out how.

What is Interest?

  • Interest is simply the fee you pay to use someone else’s money.
  • Institutions like banks and other types of lenders charge interest.
  • Sometimes, bank customers can earn interest on certain accounts, usually savings accounts or a certificate of deposit (more commonly known as a CD).
  • Interest rates are typically calculated as a percentage.
  • Interest rates can fluctuate depending on some economic factors.
  • Essentially, interest rates are a way to compensate an institution or individual for taking the risk of lending money.

How Does Interest Work in the Stock Market?

Most people are familiar with interest rates due to their mortgages and credit card bills.

But interest works a little differently when it comes to the stock market.

The Federal Reserve’s funds rate is the interest that banks and credit unions pay to borrow money from Federal Reserve banks.

This rate is set approximately every six weeks, during meetings held by the Federal Open Market Committee (FOMC).

interest rates 1

Figure 1: History of The Federal Funds Rate

The Federal Reserve, or the “Fed”, uses this interest rate to keep inflation in check.

(Inflation is caused by a simultaneous increase in prices and a decrease in the purchasing value of money.)

It does this by controlling the amount and worth of money available to purchase goods.

In theory, when the Fed increases the federal funds rate, the amount of money in circulation will decrease, while the price to borrow it will increase.

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What Happens When the Federal Rate Increases?

An increase in the federal funds rate will not immediately affect the stock market. 

The primary result of increase is the expected one: banks have to pay more to borrow from the Fed.

That’s essentially the first effect of any increase in interest rates.

interest rates 2

Figure 2: Estimated rate increase patterns in 2015, despite wage growth and a high employment rate (Business Insider)

The consequences of an increase might not be immediately evident in the stock market, but they can have a ripple effect on individual consumers and businesses alike very quickly.

Here’s how:

  1. Banks will first have to increase their interest rates since they now have to pay more to access the money they lend to their customers.
  2. Both mortgage and credit card interest rates will increase. This is especially unfortunate for homeowners or other types of borrowers who have variable interest rates.
  3. As a result, consumers will have less disposable income, causing them to decrease their discretionary spending.
  4. The decline in spending will directly affect companies’ revenue, potentially resulting in a drop in profit.
  5. Let’s not forget businesses borrow money from banks, too – when the rate increases, companies are less likely to borrow and will also lose money by paying the higher rate.
  6. Businesses will then have less money to spend and will, therefore, spend less; a decrease in spending can often impede the growth of a company.
  7. When a company cannot grow, it cannot increase profits.

How Does the Increase Affect the Stock Market?

Of course, increasing the federal funds rate will immediately and directly influence the way consumers and businesses spend their money. 

Those changes in spending are what will eventually affect the stock market.

One way of appraising a company is by determining the sum of that company’s expected future cash flows, discounted back to the present.

In order to calculate a stock’s price, find the sum of the future discounted cash flow and divide that value by the number of shares available.

People’s assumptions about or attitudes toward the company can also influence that price at a given time.

Depending on the correlation between the two, consumers might be more or less willing to invest at different prices.

If a business has decreased spending or is earning less profit, the likely consequence is that their expected future cash flows will drop.

Assuming all other financial aspects of the company are equal, the price of the company’s stock will decline as a result.

If several businesses experience these decreases, the whole market is at risk of going down.

How Does this Affect Investment?

No investor wants the market to go down; they want to watch their investments accrue value rather than lose it.

That’s one of the primary reasons they invest in the market in the first place.

Stock price appreciation and payment of dividends help investments gain value. 

When an increase in the federal rate hinders a company’s ability to grow, investments will not grow as much from stock price appreciation.

If investments stop growing, people will be more reluctant to invest.

Owning stocks could also be considered riskier when the rate goes up.

Government securities like Treasury bills and bonds are considered safer investments when the Federal funds rate increases.

Their interest rates will rise also.

However, because the “risk-free” rate of return increases, these types of investments are considered more beneficial during times of increased interest rates.

When traders invest, it’s important that they are compensated for the extra risk they are taking by making the investment – a premium above the risk-free rate.

The ideal return for investing is determined by taking the sum of the risk-free rate and the risk premium.

Investors’ risk premiums vary, depending on the companies they invest in, and how much they are willing to risk.

When the risk-free rate goes up, the result is an increase in the total return needed to invest.

A lower risk premium and a stable or decreased potential return might lead investors to surmise that the stock market has become risky.

Summing Up: The Fed Rate, the Stock Market, and You

The Federal Reserve interest rate has a profound influence on the economy:

  • When the rate increases, there is less money in circulation.
  • Though this helps to lower inflation, it causes borrowing to become more expensive.
  • When borrowing is more expensive, it directly impacts how much money consumers and businesses have to spend.
  • This results in a change in both consumer and business spending habits.
  • Higher rates increase expenses for businesses, which could potentially result in a business decreasing wages to make up for the lost funds.
  • People are less likely to want to invest in the market when rates are higher.
  • So, basically decreased investments result in decrease of people investing, which in turn affect the rates

However, it is important to remember that the stock market is not a static system.

The description provided above serves to explain the phenomenon in theory.

In practice, the effects of the interest rate on the stock market might not be so clear cut.

interest rates 3

Figure 3: An example of a positive relationship between the Fed rate and the stock market

Stock values fluctuate according to many factors besides the federal interest rate.

Several aspects play a role in determining stock prices, and the interest rate is only one of many of them.

Because of this, an investor can never be sure if an increase in the federal rate will hinder (or possibly help) the stock market.

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Business

Gold ‘Frenzy’ To Build Around Election, Platinum Could Soar 50% By Year-End

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Gold ‘Frenzy’ To Build Around Election, Platinum Could Soar 50% By Year End

Peter Hug, head of the precious metal division at Kitco, believes the Fed’s decision to hold interest rates at near-zero through at least 2023 is bullish for precious metals and particularly gold. He also mentioned the road platinum can head to by the year’s end.

“About three Fed meetings ago they indicated they would hold rates at pretty much zero through the end of 2021 into early ‘22, today they’ve extended that by an additional year, there have been some analysts that are suspecting they will keep rates at zero right through 2024, so we’ve got another almost four years of zero interest rates to look forward to,” said Hug.

“The Fed being a bit more accommodative on inflation indicates to me that it’s a very positive environment for hard assets in general but I think the metals as well will continue to move higher over the next period of time based on the dovishness of the Fed, global central banks and the uncertainty of the US election coming up in about six weeks.”

The State of the Gold and Silver Markets

Hug said the current consolidation phase is a great sign of the overall health of the gold and silver markets. This comes after the frenzy in the gold and silver markets about a month ago.

“The market has been consolidating, which is a very good sign, especially for gold. Gold has been consolidating between our support level of 1925 and 1975 for the better part of two weeks. Silver seems to be between $26.50 – $27.50 range and consolidating as well. The fact that people are not selling into a market that is as frenetic as it was a month or six weeks ago, indicates to me that this market is setting up for the next leg higher once we get through this consolidation phase.”

Availability and Premiums

The gold and silver markets are taking a bit of a breather and the mania has slowed a bit. With this, Hug said the availability of gold and silver coins is getting better. He said premiums are coming down as well.

“On the gold and silver side, dealers are starting to show inventory. That’s not a result of increased production, it’s more a result because of this consolidation phase, retail investors have started to pull back on the markets so there’s not as much buying frenzy in the physical space right now, I think that changes if gold gets north of $2,000 again. But this consolidation of $50 range in gold and the $1, $1.50 range in silver has basically dried up the demand at these levels.”

“So production is still coming on board and dealers are starting to build inventory. And because of that you are seeing premiums come down. Silver maple leafs you can get, again, depending on quantity, somewhere between $5-6 over spot, Eagles are down somewhere between $5-7 over spot, so you are starting to see as this market stays sideways and we don’t see another rush into the buying side from the retail investor, you give it another 2-4 weeks and I think there will be reasonable inventory on the market and premiums should come down.”

Volatility to Return Soon?

Hug said that if you are looking to acquire gold and silver coins, you shouldn’t wait long as we could see volatility return very soon.

“I caution that past October 15 the market is going to be very volatile as we go into the election.”

Other than gold or silver, Hug sees a huge opportunity in the platinum space. There, he expects prices to climb 50% by the end of the year.

“I’m constructive platinum. It is also consolidating in the $900-950 range, but I do anticipate platinum to be north of $1000 and then look to $1200 possibly $1400 before year end.”

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Currency Trading

Dalio: Capitalism Needs Fixing, US Dollar Upended In Next 5 Years

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Dalio: Capitalism Needs Fixing, US Dollar Upended In Next 5 Years

In a recent interview with MarketWatch, Ray Dalio, the billionaire founder of Bridgewater Associates, covered a wide range of topics. These include his thoughts on capitalism, China, the US dollar as the world reserve currency, and much more.

Three Problems

Dalio says the US is facing three distinct problems and is losing ground to China in many ways.

“There are three problems that are coming together,” said Dalio. “So it’s important to understand them individually and how they collectively make a bigger problem,” said Dalio.

“There is a money and credit cycle problem, a wealth and values gap problem, and an emerging great power challenging the existing dominant power problem. What’s going on is an economic downturn together with a large wealth gap and the rising power of China challenging the existing power of the United States.”

“It’s a fact that there has been a weakening of the competitive advantages of the United States over the last couple of decades. For example, the United States lost a lot of the education advantage relative to other countries, our share of world GDP is reduced, the wealth gap has increased which has contributed to our political and social polarization.”

Challenges the U.S. Face

To illustrate the challenges that the US faces as it attempts to stay ahead of China and remain a world power, Dalio says we need to look at Britain and how they eventually lost their position as the world’s reserve currency.

“If you look at British history, the development of rival countries led them to lose their competitive advantages. Their finances were bad because they had accumulated a lot of debt. So, after World War II those trends went against them. Then they had the Suez Canal incident and they were no longer a world power and the British pound is no longer a reserve currency. These diseases almost always play out the same way.”

“The United States’ relative position in the world, which was dominant in almost all these categories at the beginning of this world order in 1945, has declined and is exhibiting real signs that should raise worries. There’s a lot of baggage. The U.S. has a lot of debt, which is adding to the hurdles that typically drag an economy down, so in order to succeed, you have to do a pretty big debt restructuring. History shows what kind of a challenge that is.”

“The United States is a 75-year-old empire and it is exhibiting signs of decline. If you want to extend your life, there are clear things you can do, but it means doing things that you don’t want to do.”

Capitalism Needs Improvements

Dalio is a capitalist (he didn’t become a billionaire through handouts). However, he does acknowledge that the system needs to be improved so that everyone has a chance at financial freedom.

“What has been shown is that capitalism is a fabulous way of creating incentives and innovation and of allocating resources to create productivity. All successful countries have uses for it. For example, communist China has chosen capitalism, which has been essential to its growth.

“But capitalism also produces large wealth gaps that produce opportunity gaps, which threaten the system in the ways we are seeing now.

“We have to be in this together. The system needs to be reengineered to do this. But if we don’t do this engineering well, we’re going to spend in an unlimited way and deal with that by creating debt that won’t ever be paid back, and we will risk losing the reserve currency status of the dollar. If we get into that position — and we’re very close — things will get much worse because we are living on borrowed money that’s financing our consumption.”

On Dollar as the World Reserve Currency

Dalio says we could see the US lose reserve currency status as soon as the next five years.

“Within the next five years you could see a situation in which foreigners who have been lending money to the United States won’t want to, and the dollar would not be as readily accepted for making purchases in the world as it is now.”

“The United States doesn’t have a good income statement and balance sheet in dealing with the rest of the world. It is running a deficit to the rest of the world that is financed by borrowing money so that we are producing liabilities.”

There is uncertainty in the markets ahead of the November election. With this, Dalio says there are two steps investors can take to protect their wealth.

“First, worry as much about the value of your money as you worry about the value of your investments. The printing of money and the debt should make you aware of that. That’s why financial asset prices have gone up — stocks, gold — because of the debt and money creation. You don’t want to own the thing you think is safest — cash.”

“Second, know how to diversify well. That includes diversification of countries, currencies and assets, because wealth is not so much destroyed as it shifts. When something goes down, something else is going up so you have to look at all things on a relative basis. Diversify well and worry about the value of cash.”

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Business

Fed Keeps Rates At Zero, Powell Says More Fiscal Support Needed

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Fed Keeps Rates At Zero, Powell Says More Fiscal Support Needed

The Federal Reserve wrapped up its last meeting before the November elections. It announced that it would keep rates at essentially zero until at least 2023. This serves as a signal that it doesn’t see inflation as an issue at all for the foreseeable future.

Fed Chairman Jerome Powell said, “We’re going to continue to monitor developments, and we’re prepared to adjust our plans as appropriate.”

“With inflation running persistently below this longer run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved,” the Fed’s post-meeting statement said.

Uncertainty and the Stock Market

However, the Fed’s latest projections have core inflation staying below their 2% target until 2023. This leaves many observers unsure of the Fed’s actual plan to spur the inflation they desire. This uncertainty caused the stock market to drop after the announcement.

“He noted that targeting an inflation overshoot for ‘some time’ as the statement says, means that they are not targeting a ‘sustained’ overshoot. So how long is ‘some time’ if it isn’t sustained?'” asked AB economist Eric Winograd. “That imprecision is a problem that the committee is going to have to solve to reap the full benefits of the framework shift. It’s not a coincidence that the stock market, which had been in positive territory, flipped negative after the chair’s comments.”

“He’s the great and powerful Oz. Investors got duped. They thought enhanced forward guidance meant something, but when they peeked behind the curtain they realized the Fed didn’t do anything, and the market rolled over,” said Michael Arone, chief investment strategist at State Street Global Advisors.

Jon Hill, a senior fixed-income strategist at BMO, added “This is dovish – lower rates for longer, higher equities, weaker dollar. The Fed is saying we’re not hiking in 2023, maybe in 2024 … What they’re saying is these are our goals. We expect to have just barely met them and even then, they’re not raising rates.”

Stimulus and Economic Recovery

Stepping ever-so-slightly into the political realm, Powell said that Congress should pass another stimulus package to support the economic recovery. He then identified unemployment aid, small business relief and funding for state and local governments as three key areas.

“More fiscal support is likely to be needed,” Powell said. “The details of that are for Congress, not the Fed.”

Republicans have repeatedly stated that they won’t provide additional funding to bailout poorly managed cities and states as part of any additional stimulus bills.

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