How Interest Rates Affect The Stock Market

Interest rates. Most people pay attention to them, and they can impact the stock market. But
why? In this article, we'll explain some of the indirect links between interest rates and the
stock market and show you how they might affect your life.
The Interest Rate
Essentially, interest is nothing more than the cost someone pays for the use of someone
else's money. Homeowners know this scenario quite intimately. They have to use a bank's
money (through a mortgage) to purchase a home, and they have to pay the bank for the
privilege. Credit card users also know this scenario quite well - they borrow money for the
short term in order to buy something right away. But when it comes to the stock market and
the impact of interest rates, the term usually refers to something other than the above
examples - although we will see that they are affected as well. (To read more, see Who
determines interest rates?)
The interest rate that applies to investors is the U.S. Federal Reserve's federal funds rate.
This is the cost that banks are charged for borrowing money from Federal Reserve banks.
Why is this number so important? It is the way the Federal Reserve (the "Fed") attempts to
control inflation. Inflation is caused by too much money chasing too few goods (or too much
demand for too little supply), which causes prices to increase. By influencing the amount of
money available for purchasing goods, the Fed can control inflation. Other countries' central
banks do the same thing for the same reason.
Basically, by increasing the federal funds rate, the Fed attempts to lower the supply of
money by making it more expensive to obtain.(To see more on the Federal
Reserve, readGet To Know The Major Central Banks, The Fed Model And Stock Valuation:
What It Does And Does Not Tell Us and Formulating Monetary Policy.)
Effects of an Increase
When the Fed increases the federal funds rate, it does not have an immediate impact on the
stock market. Instead, the increased federal funds rate has a single direct effect - it
becomes more expensive for banks to borrow money from the Fed. However, increases
in the discount rate also cause a ripple effect, and factors that influence both individuals and
businesses are affected.
The first indirect effect of an increased federal funds rate is that banks increase the rates
that they charge their customers to borrow money. Individuals are affected through increases
to credit card and mortgage interest rates, especially if they carry a variable interest rate.
This has the effect of decreasing the amount of money consumers can spend. After all,
people still have to pay the bills, and when those bills become more expensive, households
are left with less disposable income. This means that people will spend less discretionary
money, which will affect businesses' top and bottom lines (that is, revenues and profits).
Therefore, businesses are also indirectly affected by an increase in the federal funds rate as
a result of the actions of individual consumers. But businesses are affected in a more direct
way as well. They, too, borrow money from banks to run and expand their operations. When

the banks make borrowing more expensive, companies might not borrow as much and will
pay a higher rate of interest on their loans. Less business spending can slow down the
growth of a company, resulting in decreases in profit. (For extra reading on company
lending, read When Companies Borrow Money.)
Stock Price Effects
Clearly, changes in the federal funds rate affect the behavior of consumers and business,
but the stock market is also affected. Remember that one method of valuing a company is to
take the sum of all the expected future cash flows from that company discounted back to the
present. To arrive at a stock's price, take the sum of the future discounted cash flow
and divide it by the number of shares available. This price fluctuates as a result of the
different expectations that people have about the company at different times. Because of
those differences, they are willing to buy or sell shares at different prices.
If a company is seen as cutting back on its growth spending or is making less profit - either
through higher debt expenses or less revenue from consumers - then the estimated amount
of future cash flows will drop. All else being equal, this will lower the price of the company's
stock. If enough companies experience a decline in their stock prices, the whole market, or
the indexes (like the Dow Jones Industrial Average or the S&P 500) that many people
equate with the market, will go down. (To learn more, check out Why Do Markets
Move?, Forces That Move Stock Prices and What causes a significant move in the stock
market?)
Investment Effects
For many investors, a declining market or stock price is not a desirable outcome. Investors
wish to see their invested money increase in value. Such gains come from stock price
appreciation, the payment of dividends - or both. With a lowered expectation in the growth
and future cash flows of the company, investors will not get as much growth from stock price
appreciation, making stock ownership less desirable.
Furthermore, investing in stocks can be viewed as too risky compared to other investments.
When the Fed raises the federal funds rate, newly offered government securities, such
Treasury bills and bonds, are often viewed as the safest investments and will
usually experience a corresponding increase in interest rates. In other words, the "risk-free"
rate of return goes up, making these investments more desirable. When people invest in
stocks, they need to be compensated for taking on the additional risk involved in such an
investment, or a premium above the risk-free rate. The desired return for investing in stocks
is the sum of the risk-free rate and the risk premium. Of course, different people have
different risk premiums, depending on their own tolerance for risk and the company they are
buying. However, in general, as the risk-free rate goes up, the total return required for
investing in stocks also increases. Therefore, if the required risk premium decreases while
the potential return remains the same or becomes lower, investors might feel that stocks
have become too risky, and will put their money elsewhere.
Interest Rates Affect but Don't Determine the Stock Market
The interest rate, commonly bandied about by the media, has a wide and varied impact
upon the economy. When it is raised, the general effect is to lessen the amount of money in
circulation, which works to keep inflation low. It also makes borrowing money more

expensive, which affects how consumers and businesses spend their money; this increases
expenses for companies, lowering earnings somewhat for those with debt to pay. Finally, it
tends to make the stock market a slightly less attractive place to investment.
Keep in mind, however, that these factors and results are all interrelated. What we described
above are very broad interactions, which can play out in innumerable ways. Interest rates
are not the only determinant of stock prices and there are many considerations that go into
stock prices and the general trend of the market - an increased interest rate is only one of
them. Therefore, one can never say with confidence that an interest rate hike by the Fed will
have an overall negative effect on stock prices.

Inflation And Stock Market

Inflation is a state in the economy of a country, when there is a price rise of goods as
well as services. To meet the required price rise, individuals have to shell out more
than is presumed. With increase in inflation, every sector of the economy is affected.
Ranging from unemployment, interest rates, exchange rates, investment, stock
markets, there is an aftermath of inflation in every sector. Inflation is bound to impact
all sectors, either directly or indirectly. Inflation and stock market have a very close
association. If there is inflation, stock markets are the worst affected.

Inflation and stock market- the logistics:

Prices of stocks are determined by the net earnings of a company. It
depends on how much profit, the company is likely to make in the long run
or the near future. If it is reckoned that a company is likely to do well in the
years to come, the stock prices of the company will escalate. On the other
hand, if it is observed from trends that the company may not do well in the
long run, the stock prices will not be high. In other words, the price of
stocks are directly proportional to the performance of the company.In the
event when inflation increases, the company earnings (worth) will also
subside. This will adversely affect the stock prices and eventually the
returns.
Effect of inflation on stock market is also evident from the fact that it
increases the rates if interest. If the inflation rate is high, the interest rate is
also high. In the wake of both (inflation and interest rates) being high, the
creditor will have a tendency to compensate for the rise in interest rates.
Therefore, the debtor has to avail of a loan at a higher rate. This plays a
significant role in prohibiting funds from being invested in stock markets.
When the government has enough fund to circulate in the market, the cost

of goods, services usually go up. This leads to the decrease in the

purchasing power of individuals. The value of money also decreases. In a
nut shell, for the economy to flourish, inflation and stock market ought to be
more conforming and predictable.

Why Inflation Doesnt Bother Me

Posted by The Weakonomist in Monday, February 22nd 2010

Comments Off

A fellow blogger over at Free Money Finance recently posted a concern of his, and mine. Inflation
could be just around the corner, and I dont want all of my money wiped out because I lose my buying
power. Think about your nest egg, if inflation shoots up and stock market performance doesnt keep
up then you are going to lose money in the long run. Many people cite precious metals as a great
hedge for inflation. I just dont buy it. For one thing its easy to show that precious metals are a great
hedge, or a bad one, depending on when you actually invest in them. For the other, I just dont think
precious metals are very precious anymore. They arent a primary currency, and have little industrial
application. Like a dollar, people just believe in gold. If they they can lose faith in the dollar, they can
lose faith in gold.
But that only explains that precious metals like gold may not be a good investment to protect yourself
against inflation. That doesnt explain why Im not worried about inflation.To figure out why Im not
worried, we have to look at why people are worried. Traditionally, we all put our investments in stocks
and bonds. We dont want bonds during inflation because the fixed interest rate would kill us. A 5%
bond looks great if inflation is 0% but if inflation is 10% youre getting killed. Likewise, people worry
about the macroeconomic effects on the stock market were inflation to become a problem. Inflation
raises prices on everything, and so we can afford less. We buy less and companys dont make
enough money. The stock market suffers.
So we look for alternative investments that will protect us in the case of inflation. They have Treasury
Inflation Protected Securities, otherwise known as TIPS, which are government bonds with an interest
rate that changes with inflation. But this will only give you a marginal premium over inflation, and most
people dont want to hold them during period of low inflation, so they can take advantage of better
returns. What we are looking for then is an asset class that we can hold all of the time, that offers
decent returns and some kind of protection from inflation. Youve got real estate, commodities, private
business, cash in a Folgers can, and some other options. But these options are usually difficult for the
layman to get into, or they dont understand them, or they dont offer the kind of liquidity they need.
What is a guy to do to get some inflation protection around here?
Remember before when I said during periods of inflation businesses suffer and so the stock market
does too? Thats not actually true. Inflation exists because more money is available to purchase the
same amount of goods. Supply and demand, we have a large supply of money and demand the same
goods. The result is price inflation. Inflation requires high levels of demand. If we are not making
purchases the prices will fall. So in the case of price inflation business sales and revenues should look

fairly good. In theory, the businesses themselves will have to pay higher prices for the goods they
purchase, but that isnt always the case. Even if it were, for us to experience inflation the businesses
would have to be passing on those expenses to us. The net effect is that inflation doesnt really matter
to businesses. Yes there are exceptions, but the NET effect in business is a wash.
Whats the point to all this? My point is Im not concerned about inflation so long as my nest egg is
invested in stocks Im not one bit worried about inflation. To back up my claim Ive done a little
research. This marks maybe the second or third time ever that Ive put more than 20 minutes into a
post. Its usually easier to speculate and let someone else do the research but I wanted to know for
myself this time.
Below is a table I made. It contains the 20 highest inflation rates in the United States since the end of
WWII and the return for the S&P 500 in that year.

Year

Inflation Rate
1990
1989
1984
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1971
1970
1969
1951
1948
1947
1946

Maximum
Minimum
Median
Average
St Deviation
Beta

S&P 500
5.39%
4.83%
4.30%
6.16%
10.35%
13.58%
11.22%
7.62%
6.50%
5.75%
9.20%
11.03%
6.16%
4.30%
5.84%
5.46%
7.88%
7.74%
14.65%
8.43%

Summary Statistics
14.65%
4.30%
7.06%
7.82%
0.03

-3.42%
32.00%
5.96%
21.22%
-5.33%
32.76%
18.69%
6.41%
-7.78%
24.20%
38.46%
-26.95%
-15.03%
14.54%
3.60%
-8.63%
23.10%
9.51%
2.56%
-12.05%

38.46%
-26.95%
6.19%
7.69%
0.18
0.11

At first glance it doesnt look like much. Its a bunch of numbers that dont seem to really act the
same. Sometimes inflation is really high and the S&P does well. Sometimes the S&P does terribly.
However if you take the average inflation rate and compare it to the average S&P return, the
averages are very similar. The S&P return is only slightly less, and Im sure a statistics nerd with a ztable could back me up on this, this difference is statistically insignificant.
What the average is showing us is that when we experience periods of high inflation, the stock market
keeps up (on average). You arent going to experience great gains, but you technically wont lose any
buying power either.
Furthermore, there is a statistical measurement known as Beta in finance. Beta usually cited in terms
of a stocks beta to a market return. For example, when a stock has a beta of 1, everytime the stock
market goes up 5%, the stock goes up 5% too. When it goes down 5%, so does the stock. In
otherwords, they are perfectly correlated. The closer the beta is to 0, the less correlation there is.
The beta of the S&P 500 with respect to inflation is 0.11, which is practically nothing. If youre looking
for an asset to protect you from inflation, you want something that isnt correlated with inflation.
The story the summary statistics are telling us is that during periods of high inflation, the stock market
keeps up on average. And, during periods if high inflation, the stock market return isnt related to the
high inflation. Its almost two stories, but its also an example a relationship without correlation.
The stock market is being stalked by the I word and investors are showing their nerves.
Inflation has The Federal Reserve Board running scared and we will all pay the price for it.
High energy prices, rising unit labor costs and pressure on supplies of key resources such
as steel and cement (thanks to Hurricanes Katrina and Rita) are lining up like some illfated stars to guarantee the Fed will continue raising short-term interest rates.
High interest rates and companies raising prices dont add up to an investment profile
most investors enjoy. However, stocks are still a good hedge against inflation because, in
theory, a companys revenue and earnings should grow at the same rate as inflation over
the time.
Global Market
While some companies can react to inflation by raising their prices, others who compete
in a global market may find it difficult to stay competitive with foreign producers who
dont have to raise prices due to inflation.
More importantly, inflation robs investors (and everyone else) by raising prices with no
corresponding increase in value. You pay more for less.
This means companys financials are over-stated by inflation because the numbers
(revenue and earnings) rise with the rate of inflation in addition to any added value
generated by the company.

Earnings
When inflation declines, so do the inflated earnings and revenues. It is a tide that raises
and lowers all the boats, but it still makes getting a clear picture of the true value
difficult.
The Feds chief inflation-fighting tool is short-term interest rates. By making money more
expensive to borrow, the Fed effectively removes some of the excess capital from the
market.
Too much money chasing too few goods is one classic definition of inflation. Taking
money out of the market slows the cycle of price increases.
There are two more meetings of the Open Market Committee (the body that sets rates) in
2005: Nov. 1 and Dec. 13.
Given the pressures mentioned earlier, you can take it to the bank that the Fed will keep
raising rates at least through the end of the year.
Investments
Should you be concerned about inflation and your investments? If you have a substantial
portion of your portfolio in fixed income securities, the answer is a definite yes.
Inflation erodes your purchasing power and retirees on fixed incomes suffer when their
nest egg buys less each passing year. This is why financial advisers caution even retirees
to keep some percentage of their assets in the stock market as a hedge against inflation.
The more cash or cash equivalents you hold, the worse inflation will punish you. A $100
under the mattress will only buy $96 worth of goods after a year of 4 percent inflation.
Look for inflation-indexed products like the Treasury I Bonds and other products that offer
a hedge against rising rates.
Conclusion
Investors should keep an eye on interest-rate sensitive stocks, since continued pressure
by the Fed will keep rates moving up through the end of the year and probably into
2006.