Learn why interest rates affects the stock markets and how to be aware of them as a trader.
Lots of people do not know that interest rates do affect the stock markets. In this article you will learn why interest rates affects the stock markets and also the premium of options.
What Is Interest Rate?
Whenever you take a loan from a bank you have to pay them extra money for the money they lend to you. Or if you pay via credit card and do not pay back the money on time then you have to pay a fine plus some interest on the borrowed money.
The extra money you pay is decided on the interest rate to lend money.
In simple terms let say A borrows money from B a sum of Rs. 100 on the condition that after one year A has to give back Rs. 110 (100 + 10) to B. In this case the interest rate is 10% on the borrowed sum for one year.
Why should A pay an interest rate to B?
This is nothing but the cost of borrowing someone else money because, why should someone give his money to someone else for free? For that the borrower needs to pay a price depending on the interest rate decided.
In stock markets no one borrows money but still interest rates does affect the stock markets.
Recently there was a big news on FED interest rate hike. Interestingly traders all over the world were waiting for the news but others were not so interested. We will shortly know why Interest rates affects the stock markets.
In the US banks borrow money from the Federal Reserve Bank to do business and pay an interest rate to Federal Reserve Bank. If FED increases interest rate, the cost of borrowing money from FED will increase and it is obvious that these interest rate increase will be passed on to the consumers. In effect all loans like mortgages, personal and business loan rates will increase. Since the interest rates will increase on loans, their demand will go down.
When their demands goes down, the system will have less money to buy things. When the system will have less money to buy things, demand will be less than supply. This will obviously lower the cost of products and services in the markets or keep them stable.
This is how central banks all over the world control Inflation. In US central bank is Federal Reserve Bank, in India it is the Reserve Bank of India (RBI).
What Happens When Interest Rates Are Raised By Central Banks
In the very short term not much is affected. But over the long run the affects can be seen.
Borrowing money from the Central Banks becomes costlier by the banks, therefore liquidity of money in the system goes down. Why? Because when borrowing money becomes costlier banks cannot pay the interest from their pockets, they will pass it on to the consumers. This affects an increase in the interest rates in mortgage loans, credit cards, personal loans, car loans, business loans and other kinds of loans. Therefore both individuals and businesses are affected.
When loans gets costlier both individuals and businesses borrow less money from banks.
When businesses are affected they will again raise the price to their products or services to consumers to remain profitable.
Do not forget that demand of products does not goes down drastically as people have to buy these products to continue living. Although due to less cash in the system and costlier products, the demand of the products does goes down to some extent. Lower demands does affect businesses revenues and profits.
When Central banks increase interest rates, it becomes difficult for businesses to borrow more money to expand their business. They start borrowing less, therefore the speed of growth of businesses also goes down.
Over the long term, businesses borrowing less money brings down the stock prices down of these companies. We will read shortly how.
Therefore, businesses are indirectly and directly affected by an increase in the central bank rates.
If rates are low – more business loans, more business and more profits, if rates are high – less loans and less business and less profits.
How Increase or Decrease in Central Bank Rates Affects Stock Prices
When businesses revenues and profits is affected it is obvious that the stock prices of these businesses also goes down as the profits do not meet expectations of the markets.
Retail investors trade in speculations but this is not the case with HNI (High Net-worth Individuals), and DIIs (Domestic Institutional Investors) like mutual funds. These people have a lot of money to risk, they cannot speculate and trade.
Their first priority is the fundamentals of the company.
One of the best methods of valuing a company is to see expected future cash flows from that company compared to present cash flows. Future cash flow comes from the expected growth of a company. When they see that a company may not be able to expand fast and may slow their growth they become skeptical to invest in that company.
When they see that the future situation does not show a great picture for a company, they invest less in that company or do not invest at all to reduce risk. This obviously decreases the stock price.
How Does The Stock Price Effects Investment
Retail traders look at the current situation of the stock price and invest. When the Institutional investors reduce their investments in these stocks, these stocks starts to fall and is seen by retail investors. It is obvious that they get tempted and sell their stocks. This is a simple reason why retail investors sell when the markets fall and buy when the markets go up and lose money in the long run. In reality they should buy more when the stocks are falling and sell to book profits when the stocks are rising. Unfortunately since the birth of stock markets retail investors are doing this mistake time and again and will continue to do so.
Conclusion of the Affects of Interest Rates In Stock Markets
- When Interest rates are hiked it becomes costlier for banks to borrow money from Central Banks
- They pass these higher interest rates to consumers so rates on all loans like home, car, personal and business loans goes up
- Due to the above, cash in the system decreases and demand of products slows down
- When business loan rates goes up, businesses borrow less money and their speed of growth slows down
- When business growth speed slows down, it affects their prices and stocks begins to fall
- Vice-versa when the Central Banks lower their interest rates.
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