Foundations of Finance: Impact of Interest Rates on Equities
Interest rates are something nearly everyone is familiar with, and likely not a fan of. An interest rate is a cost associated with borrowing money from any given source. The most well known interest rates are that of mortgage and credit card interest rates. However, there are various forms of interest rates that the average consumer may not be aware of. Perhaps the most important to be aware of when evaluating the equity markets is the Federal Reserve’s federal funds rate. This rate reflects the cost that banks must pay in order to borrow money from the Federal Reserve.
The well known economic model of supply and demand plays a large factor when considering the purpose and power of the Federal Reserve interest rate. The Federal Reserve uses this borrowing rate in order to control inflation, which has a direct impact on consumers and business alike. For instance, when the Federal Reserve rate is increased, it results in a higher cost for banks to borrow money which in return decreases borrowing or increases cost. When banks borrow less money, there is less money for business and consumers to borrow, and thus less money in circulation. This allows direct control over inflation. From the opposing side, as seen during the recent recession, when Fed rates are lowered, banks and consumers are inspired to borrow more at a lower cost which then puts money back into the economy and increase overall cash flow.
So what does this have to do with the stock market? Well, anytime you impact the spending habits, cost of borrowing, and expenditures of consumers and business’, you impact the start market. Stock performance is driven by the company performance as well as economic market conditions and outlook. Simply put, when people and business are spending less, profit reduces, and stock value drops. The same concept applies to credit card rates and mortgage rates, if they increase then consumers have less disposable income and businesses suffer as a result.
Where do bonds come into play? A bond is considered a “safe haven” investment when markets become volatile and suffer from poor economic conditions. Bonds will experience an increase in the rate of return while the purchaser will gain confidence by putting money into a more risk reduced investment. When the Federal Reserve raises interest rates, bonds will normally see a direct correlation and also increase in interest rate yields. However, this time the investor is on the receiving end as someone is borrowing the money from them. As a result of a buying a bond that promises a certain yield, when the price of the bond fluctuates, the yield moves in the opposite direction. For example if a bond reduced in price, the yield is higher in order to maintain your return percentage.
Interest rates directly impact each and every consumer, whether they realize it or not. It is important that consumers understand the impact of interest rates, bond pricing, stock market fluctuations and inflation control in order to better protect their net worth and reallocate their assets as necessary.
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