Why Stocks are Affected when the CB Plays with Interest Rates
These days, a lot of people have their eye on interest rates – mainly to criticize the absurdly low rates on cash accounts but also to rave over the low rates they get on mortgages and loans. There a few links between interest rates and the market and we’ll look at ways you can use this to your advantage in the long run.
Interest is simply the cost (in percentage) that someone pays for the use of another persons or institutions money. The interest rate is governed by the Central Bank in order to use it as a stimulus for the economy, controlling inflation and the cost of borrowing.
Why do rates go up and down?
If we look at the situation right now, rates are sitting at low levels. Obtaining money through borrowing is very cheap. The reason for this is the CB wants people to take out loans to stimulate the economy and spur economic growth. The more money consumers filter through the system through spending allows bottomlines to grow and companies to expand. Since banks offer low rates for your cash accounts, they are also hoping you don’t hold onto that money and use it elsewhere. Since mortgages are cheaper – the lower interest generates more savings leaving consumers with greater discretionary income.
Bottomline: Borrowing is cheaper = less expensive to obtain == more supply
If we flip the script when rates are high – we are looking at the opposite situations. Money is harder to obtain as rates are higher and people are reluctant to take out money on loan at higher rates. For those with mortgages up for renewal or variable mortgages (mortgages where the rate is not set) the cost of borrowing will be higher. Consumers are left with less money due to higher rates.
Bottomline: Borrowing is more expensive == less supply
Okay… but how does it affect the stock market?
The whole idea rests on the idea of discretionary income. This is the money left over after taxes, mandatory charges and expenses. If rates are higher, people will be using more money to pay bills, mortgages, credit card loans and other expenses. In turn due to less discretionary income people are less likely to buy goods and services. Businesses will suffer and the drop in spending and consumer traffic will take its toll on profits, future growth and cash flow. Due to a higher cost of borrowing, companies are less likely to take out loans for research, acquisitions and business development which can slow growth. When rates are lower, an opposite reaction occurs.
What happens to my investments?
In a nutshell, the stock price of a company relies on the future cash flows, dividends and profit growth expectations. Each of these factors is likely to be affected by higher interest rates which may drive the price down.
The Good You Ask?
People are always very quick to criticize a decrease in their discretionary income but also note that since interest rates go up so will the rate on your cash accounts, GIC’s and other investments. Banks will pay you a higher rate for keeping your money there and newly issued bonds or treasury notes will bear a higher interest rate.
Always remember that just because interest rates go up and down the expected counter-reaction is NEVER GUARANTEED. Look at the above chart and in many cases when interest rates were raised the market responded by going up. Never base your decision solely on interest rates.
Disclaimer: All of the above information is my own personal opinion. Please exercise caution when making any financial decision. The information presented above is also very broad and basic and should not be used as your only resource.