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Rising interest rates can negatively affect stocks, at least in the short term. In the long term, the answer is less clear because stock prices depend on interest rate changes as well as other factors. These include economic indicators, such as employment and corporate earnings, and fiscal policy measures, such as taxes and budget deficits.
The U.S. Federal Reserve sets the direction of short-term interest rates by adjusting the federal funds rate, which is the rate at which banks lend money to one another. According to a Federal Reserve Economic Data plot of the federal funds rate versus the S&P; 500 index, rising interest rates have not negatively affected stocks since the early-1990s. However, stock prices did stagnate through the 1970s and into the early-1980s, probably because interest rates were often in the double digits and remained high over a sustained period. The S&P; 500 index is a broad market index that tracks the market prices of 500 large U.S. companies across different industry sectors.
The Federal Reserve increases interest rates to slow down the pace of economic growth and control inflation. Rising rates could slow down the economy, which would negatively affect stocks. This is because higher interest rates mean higher borrowing costs for individuals and businesses, which lead to lower consumer and business spending. This reduced demand for goods and services leads to lower corporate revenues and profits. Stock markets tend to anticipate this earnings slowdown. Analysts may start lowering earnings expectations which would hurt stock prices. However, if rates do not rise too high, the economy continues to perform without showing signs of inflation and businesses report consistent earnings, stock prices may continue to rise. This is what happened through the better part of the 1990s and the 2000s, at least until the 2008 financial crisis.
Rising interest rates typically lead to rising yields on fixed-income investments, such as certificates of deposit, Treasury bonds and corporate bonds. Investors may switch from stocks to interest-bearing assets to take advantage of the higher yields. Bond prices may also benefit from safe-haven buying as investors flee volatile stock markets, especially during a period of rising rates, to the relative safety of bonds. The falling demand for equities could depress stock prices to the point where some stocks might represent attractive buying opportunities.
Stock and bond markets generally price in the effect of rising interest rates. The members of the Federal Reserve generally telegraph their intentions in public speeches and interviews long before any formal announcement of interest rate changes. During a period of rising rates, some investors tend to move out of interest-rate sensitive sectors, such as financial services, into defensive sectors, such as household goods and healthcare.