The U.S. Federal Reserve adjusts the federal funds rate, which is the main short-term interest rate, to control inflation and spur economic growth. Changes to short-term rates affect long-term interest rates and various economic indicators, including the stock and bond markets. Rising interest rates mean higher interest expenses on everything from credit cards to business loans. This affects individual and corporate spending decisions, which in turn influences investment valuations.
Actual or expected changes in interest rates can influence stock prices. Rising interest rates usually result in falling stock prices, at least in the short term. However, stock markets often rise during rising interest rates. For example, markets rose through the mid-1990s and the mid-2000s even though the Federal Reserve raised rates several times. However, markets did not fare well during the rate increases of the 1970s and the 1980s because inflation and other economic fundamentals were also weak. Stock prices are going to fall if investors perceive that rising interest rates will have an adverse impact on corporate earnings.
Interest rates are inversely related to bond prices, but not all bonds lose value at the same rate. The prices of bonds that mature later are affected less than the prices of short-term bonds. Government bond prices usually fall and yields rise with rising interest rates. However, these prices may hold up if investors abandon stocks and other risky assets in favor of risk-free U.S. Treasury bonds during periods of economic uncertainty. Riskier bonds, such as corporate investment-grade bonds or junk bonds, also experience rising yields but do not benefit from the safe-haven buying that Treasuries can experience during market downturns.
Rising interest rates mean rising mortgage rates, which mean less affordable homes. However, if rates are rising because the Federal Reserve wants to put the brakes on an overheating economy, housing prices may not be affected. More people have jobs and can afford homes in strong economic times, even if their mortgage payments rise because of high interest rates. Homebuilders may provide incentives, such as lower downpayments and longer mortgage periods, to attract more homeowners. Prices may also hold up if rising interest rates lower the home resale values in certain areas, thus convincing some homeowners to stay in their homes.
Rising interest rates usually slow down consumer spending and business activity, which dampens commodity demand and prices. However, falling U.S. demand may be offset by rising demand in China and Brazil, thus stabilizing commodity prices. The price of some commodities, such as gold, may experience strong rallies during periods of rising rates because investors see these commodities as inflation hedges.
- Federal Reserve Bank of St. Louis: FRED Graph: Federal Funds Rate and the S&P 500
- Federal Reserve Bank of St. Louis: FRED Graph: Federal Funds Rate and 10-Year Treasury Bond Yields
- Federal Reserve Bank of St. Louis: FRED Graph: Federal Funds Rate and Corporate AAA Bond Returns
- Federal Reserve Bank of St. Louis: FRED Graph: Federal Funds Rate and the Composite Housing Index
- U.S. Federal Reserve: How Does Monetary Policy Influence Inflation and Employment?
- 3d line chart image by Pos Dmitry from Fotolia.com