The Effects of Interest Rates on Common Stocks
Stock market investments help generate independent wealth. To invest strategically and build wealth, it is critical that all savers recognize the interplay between prevailing interest rates and the stock market. With this knowledge, investors can best better able to put together a diversified portfolio that accommodates financial growth, while also managing risks. Interest rates are synonymous with “the cost of money.”
Corporations raise capital by issuing shares of stock to owners and debt to creditors. In exchange for loaning money out to corporations, creditors collect interest payments on their bond and money market securities. Share prices, as reflections of ownership stakes, generally track corporate profits. For individual corporations, low interest rates that reduce financing costs should translate into improved profitability and higher share prices. Alternatively, a corporation may struggle to make good upon debt payments amid a high interest rate environment. Share prices would then collapse toward zero–if the corporation were to face the real prospects of imminent loan default and bankruptcy.
Common stock investments compete against bank deposits and fixed income securities for investment dollars. Compared to common stocks, bank deposits and fixed income assets, such as bonds, are low-risk investments. In a high interest rate environment, share prices are likely to fall as money flows out of the stock market and into bank deposits and fixed income. With high interest rate payments, these conservative investments offer decent returns–for minimal risk. In a low interest rate environment, however, investors are more so likely to accept stock market volatility–for the opportunity to earn high investment returns. Credit securities make minimal payments amid low rate environments.
The Federal Reserve
In America, the Federal Reserve Board manages the prevailing interest rate environment through its influence over the money supply. Through open market transactions, The Fed may purchase U.S. Treasuries to improve liquidity. The Fed works to target lower interest rates amid recession–to stimulate the economy by encouraging people to take out loans and invest money. Stocks overall, often post strong gains in response to news of a Fed rate cut. Alternatively, the Fed will sell Treasuries to restrict the money supply and target higher interest rates when inflation is a concern. Be advised that stock market returns may stagnate amid a Federal Reserve a campaign to raise interest rates.