The Effect of Interest Rates on Stock Market

by Kevin Johnston Google

    The stock market reflects the overall health of the economy. One measure of that health is rising or falling interest rates. The Federal Reserve raises or lowers interest rates to fight inflation or make it easier for companies to borrow money. Most commercial lending institutions follow the Federal Reserve's lead. All of this up-and-down adjustment affects the stock market. Investors have to learn to calculate the impact of rate changes on stock prices.

    Stock prices depend on company profitability. When companies have to pay more to borrow money, the additional interest expense eats into company profits. If investors perceive that companies can't make up for the lost profits, stock prices may drop. Higher interest rates signal investors to monitor company profits to see if the stock price is too high because it is based on old assumptions about interest rates. On the other hand, declining interest rates signal cheaper borrowing for companies. This can influence a rise in stock prices if investors perceive that companies will spend less of their profits on interest.

    High interest rates can cause businesses to stop purchasing large assets. Companies would find a need to borrow in order to make those purchases. Some companies won't want to take on new interest expense that comes with buying large equipment and buildings. Because businesses purchase assets to produce income, a reduction in asset acquisition can keep income from growing. Investors who perceive a lack of company growth may decide to sell company stocks, thus driving stock prices down. When interest rates move lower, companies may decide to purchase new assets. The resulting increase in income can drive stock prices higher if investors anticipate growth from the purchase of assets.

    Some investors value stocks based on a company's current cash flow and anticipated cash flows. Rising interest rates can reduce a company's cash flow in the future because more cash will go to pay interest charges. This possible reduced cash flow can drive a company's stock down in price. If several companies anticipate reduced cash flow, the stock market overall could see a reduction in stock prices. Investors might expect all companies to suffer lower cash flows due to high interest rates. On the other hand, falling interest rates can leave more cash left over for businesses. Investors who see a company's growing cash stockpile may be willing to pay a higher price for its shares.

    Rising interest rates do not automatically result in dropping stock prices, and falling interest rates do not necessarily mean more cash and profits for companies, and therefore higher stock prices. If investors perceive that the Federal Reserve raises interest rates to keep inflation down, that can be good for businesses. Stocks might rise in that circumstance. Similarly, if investors think the Federal Reserve is lowering rates because of a declining economy, stocks may seem less attractive and market prices could go down.

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    About the Author

    Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.

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