Interest rates have a massive impact on the whole economy, and influencing the rate is one of the strongest tools at the disposal of a central bank. The central bank sets a target interest rate and accepts deposits or loans out money in an effort to influence market rates, forming an important part of monetary policy. Interest rates can have a major impact on stocks and other investments.
Risk and Return Analysis
Every investor has a level of risk that is acceptable, and that level is comprised of the potential returns against potential losses. It makes sense to put money into bonds, savings accounts and certificate of deposits if interest rates are high. However, when interest rates are very low, that money will not earn as much.
If the inflation rate is higher than the return rate on the investment, it is losing real value. The stock market tends to fall when interest rates rise as money is pulled out of stocks and put into low-risk investments. The opposite is true when interest rates fall. The effect is temporary as fundamental and macroeconomic factors take over.
Bonds have a fixed rate of return based on credit ratings of the issuing entity and the interest rate, but the par value of a bond may fluctuate based on the interest rate. Rising interest rates mean the par value drops, while declining rates mean the par value rises. CDs are set by the bank based on the interest rate.
Amount of Borrowing for Investments
When interest rates are low, it is possible to borrow large sums of money for cheap and invest them in an attempt to earn higher returns. For example, imagine borrowing money at 5 percent and investing it in the stock market for 10 percent. When interest rates fall, you can see a surge in the value of stock investments as individuals and groups like hedge funds borrow money to invest.
The longer interest rates stay low, the more leverage might end up being deployed. Investments involving lending money might see lower returns. For example, bonds would command lower interest rates.
With high interest rates, the stock market would be fueled by less borrowing. This might not mean declining values in the stock market, but it might move slower. However, investments like bonds and CDs would become more valuable since they would command higher interest rates.
Cost of Corporate Borrowing
The interest rate has serious economic consequences aside from determining how capital is deployed by investors. Companies often use debt to fund expansion, which can allow productive assets to pay themselves off by bringing in revenue for the company. Without borrowing, all expansion would have to be cash financed, which would place a real burden on a company's liquidity.
When interest rates are low, companies can use the cheap money to expand. This can be by going to a bank and securing a credit line, vendor financing when buying equipment or issuing bonds. Bonds can also be used to pay off existing debt that has a higher rate, which can improve a company's profitability.
The effect is that some companies can see their stock price increase as their expansion efforts pay off. High interest rates can eat into companies' net income through higher interest payments, or lead to lackluster growth due to slower expansion.
Costs of Consumer Borrowing
The interest rate also affects consumer spending habits. People use debt all the time to fuel purchases. When rates are low, it can be a great time to use low rates to get a personal loan, automotive loan or use a credit card. The uptick in consumer spending can help corporations realize more revenues and profit.
Consumers will still be paying some interest and that helps financial institutions realize more profits. The investment most impacted by consumer spending would be stocks.
Nihar Patel covers finance and investing for several online publications, including Seeking Alpha. He also runs his own investment analysis website. Patel holds a J.D. from UC Hastings College of Law, as well as a bachelor's degree in political science and history from UC Davis.