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Exfor: How do interest rates affect investments in the stock market?

What are interest rates? The interest rate is the price of borrowing money.

High interest rates have an impact on the financing of companies, since credits become more expensive, investments are less profitable for companies and this affects their income statement.

If interest rates are too low, there may be a risk that companies will borrow too much and have financial problems later.

Who sets interest rates?

Interest rates are set by the central banks with the greatest influence on the economy:

  • The Fed in the United States.
  • ECB (European Central Bank) in Europe.
  • The decisions of the Central Banks of England, Japan, Switzerland, New Zealand, Australia, Canada or Poland are also important.

What factors influence the rises and falls of interest rates?

There are two macroeconomic factors that are the most relevant in determining an interest rate rise or fall:

1- Inflation

If inflation rises in a country or economic zone, the country or zone will most likely have to raise the nominal interest rate to maintain its real return on money.

2- Exchange rate

To defend the exchange rate, central banks increase the interest rate, which can cause significant economic stagnation that can lead to greater mistrust in international markets. Other less relevant factors in exchange rates: employment and economic growth.

Other influencing factors are employment and economic growth (income).

The international environment is also an important factor due to the globalization of the interest rate market.

How does the interest rate affect the stock market?

When money is more expensive to obtain or to finance a project, investors tend to value more projects with close returns, since it is not easy to obtain new capital. And vice versa, if it is very cheap to raise new capital, then current money is not valued as much, so it is generally invested in longer-term projects.

What happens if interest rates drop? What sectors benefit?

Interest rates are the price of money and time, with very long-term projects being valued more, due to the ease of obtaining new money with very cheap loans.

In this situation, fixed income projects are usually the first to feel the damage, since if rates are at zero, both bonds and bank deposits cannot receive any type of return or it is very low.

Since new money is easy to raise, investors don’t mind betting on very long-term projects, so the stock market tends to rise strongly.

What happens if interest rates rise? What sectors benefit?

When interest rates rise, investors will find the Stock Market less attractive, as other markets such as the fixed income market and bank deposits will give them higher returns without risk, so fixed income will increase relative to investment in the stock market.

Therefore, they will be the sectors that work with solid projects and immediate returns. For example, the food sector, the construction sector or even the pharmaceutical sector tend to support the widespread falls that can occur in the stock market.

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Disclaimer: This content comes to us courtesy of Exfor, being the only ones responsible for the information provided here.

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