This is the fifth article in a series to explain and educate some on the ins and outs of trading currencies – and what affects their value – In the last article the factors that influence exchange rates were covered - these next articles will address - Inflation - Interest Rates – and exchange rates
This information is provided for educational purposes only and without charge or profit - It is hoped to be of great benefit for those who are newbies in the investment and have little or no prior education or training in economics and currency trading -
How Interest Rates Affect The Stock Market
Interest rates. Most people pay attention to them, and they can impact the stock market. But why? In this article, you will learn some of the indirect links between interest rates and the stock market and how they might affect your life.
The Interest Rate
Essentially, interest is nothing more than the cost someone pays for the use of someone else's money. Homeowners know this scenario quite intimately. They have to use a bank's money, through a mortgage, to purchase a home, and they have to pay the bank for the privilege.
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Credit card users also know this scenario quite well - they borrow money for the short-term in order to buy something right away. But when it comes to the stock market and the impact of interest rates, the term usually refers to something other than the above examples - although we will see that they are affected as well.
The interest rate that applies to investors is the Federal Reserve's federal funds rate. This is the cost that banks are charged for borrowing money from Federal Reserve banks. Why is this number so important? It is the way the Federal Reserve (the "Fed") attempts to control inflation.
Inflation is caused by too much money chasing too few goods (or too much demand for too little supply), which causes prices to increase.
By influencing the amount of money available for purchasing goods, the Fed can control inflation. Other countries' central banks do the same thing for the same reason.
Basically, by increasing the federal funds rate, the Fed attempts to lower the supply of money by making it more expensive to obtain.
Effects of an Increase
When the Fed increases the federal funds rate, it does not have an immediate impact on the stock market. Instead, the increased federal funds rate has a single direct effect - it becomes more expensive for banks to borrow money from the Fed. Increases in the federal funds rate also cause a ripple effect, however, and factors that influence both individuals and businesses are affected.
The first indirect effect of an increased federal funds rate is that banks increase the rates that they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if they carry a variable interest rate.
This has the effect of decreasing the amount of money consumers can spend. After all, people still have to pay the bills, and when those bills become more expensive, households are left with less disposable income. This means that people will spend less discretionary money, which will affect businesses' top and bottom lines (that is, revenues and profits).
Therefore, businesses are also indirectly affected by an increase in the federal funds rate as a result of the actions of individual consumers. But businesses are affected in a more direct way as well. They too borrow money from banks to run and expand their operations.
When the banks make borrowing more expensive, companies might not borrow as much and will pay higher rates of interest on their loans. Less business spending can slow down the growth of a company, resulting in decreases in profit.
Stock Price Effects
Clearly, changes in the federal funds rate affect the behavior of consumers and businesses, but the stock market is also affected. Remember that one method of valuing a company is to take the sum of all the expected future cash flows from that company discounted back to the present. To arrive at a stock's price, take the sum of the future discounted cash flow and divide it by the number of shares available.
This price fluctuates as a result of the different expectations that people have about the company at different times. Because of those differences, they are willing to buy or sell shares at different prices.
If a company is seen as cutting back on its growth spending or is making less profit - either through higher debt expenses or less revenue from consumers - then the estimated amount of future cash flows will drop.
All else being equal, this will lower the price of the company's stock. If enough companies experience declines in their stock prices, the whole market, or the indexes (like the Dow Jones Industrial Average or the S&P 500) that many people equate with the market, will go down.
For many investors, a declining market or stock price is not a desirable outcome. Investors wish to see their invested money increase in value. Such gains come from stock price appreciation, the payment of dividends - or both. With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable.
Furthermore, investing in stocks can be viewed as too risky compared to other investments. When the Fed raises the federal funds rate, newly offered government securities, such Treasury bills and bonds, are often viewed as the safest investments and will usually experience a corresponding increase in interest rates. In other words, the "risk-free" rate of return goes up, making these investments more desirable.
When people invest in stocks, they need to be compensated for taking on the additional risk involved in such an investment, or a premium above the risk-free rate. The desired return for investing in stocks is the sum of the risk-free rate and the risk premium.
Of course, different people have different risk premiums, depending on their own tolerances for risk and the companies they are buying into. In general, however, as the risk-free rate goes up, the total return required for investing in stocks also increases.
Therefore, if the required risk premium decreases while the potential return remains the same or becomes lower, investors might feel that stocks have become too risky, and will put their money elsewhere.
The Bottom Line
The interest rate, commonly bandied about by the media, has a wide and varied impact upon the economy. When it is raised, the general effect is a lessening of the amount of money in circulation, which works to keep inflation low.
It also makes borrowing money more expensive, which affects how consumers and businesses spend their money; this increases expenses for companies, lowering earnings somewhat for those with debt to pay. Finally, it tends to make the stock market a slightly less attractive place to investment.
Keep in mind, however, that these factors and results are all interrelated. What is described above are very broad interactions, which can play out in innumerable ways. Interest rates are not the only determinant of stock prices and there are many considerations that go into stock prices and the general trend of the market - an increased interest rate is only one of them. One can never say with confidence, therefore, that an interest rate hike by the Fed will have an overall negative effect on stock prices.
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Forces Behind Interest Rates By Reem Heakal
An interest rate is the cost of borrowing money. Or, on the other side of the coin, it is the compensation for the service and risk of lending money. Without it, people would not be willing to lend or even save their cash, both of which require a deferment of the opportunity to give up spending in the present.
But prevailing interest rates are always changing and different types of loans will offer various interest rates. If you are a lender, a borrower or both, it's important you understand the reasons for these changes and differences.
Lenders and Borrowers
The lender of money is taking a risk that the borrower may not payback the loan. Thus, interest provides also a certain compensation for bearing risk. Coupled with the risk of default is the risk of inflation. When you lend money now, the prices of goods and services may go up by the time you are paid back your money, whose original purchasing power would have decreased. Thus, interest protects against future rises in inflation. A lender such as a bank uses the interest to process account costs as well.
The borrowers pay interest because they must pay a price for gaining the ability to spend now as opposed to having to wait years and years to save up enough money. For example, a person or family may take out a mortgage for a house for which they cannot presently pay in full, but the loan allows them to become homeowners now instead of far into the future.
Businesses also borrow for future profit. They may borrow now to buy equipment so they can begin earning those revenues today. Banks also borrow in order to increase their activities, whether lending or investing, and pay interest to clients for this service.
Interest can thus be considered a cost for one entity and income for another. Interest is the opportunity cost of keeping your money as cash under your mattress as opposed to lending. If you borrow money, then the interest you have to pay is less than the cost of forgoing the opportunity to have the money in the present.
How Interest Rates are Determined
Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them. (To brush up on supply and demand relationships, see this tutorial on economics basics.)
The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, when you open a bank account, you are actually lending money to the bank.
Depending on the kind of account you open (a certificate of deposit will render a higher interest rate than a checking account, with which you have the ability to access the funds at anytime), the bank can use that money for its business and investment activities.
In other words the bank can lend out that money to other customers. The more banks can lend, the more credit there is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the re-payment of their loans. For instance, when you decide to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay, but also decreasing the amount of credit available in the market. This in turn will increase the interest rates in the economy.
Inflation will also affect interest rate levels. The higher the rate of inflation, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future.
The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often comes with out announcements about how monetary policy will affect interest rates.
The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend; the rate then eventually trickles down into other short-term lending rates.
The Fed influences these rates by the use of "open market transactions", which is basically the buying or selling of previously issued U.S. securities. When the government buys more securities, banks are injected with more money than they can use for lending, and the interest rates then decrease.
When the government sells securities, money from the banks is drained for the transaction, rendering less funds at the banks' disposal for lending, forcing a rise in interest rates.
Types of Loans
Of the factors detailed above, supply and demand are, as we implied earlier, the primary forces behind interest rate levels. The interest rate on each different type of loan, however, depends on the credit risk (which is discussed in detail in the articles What Is A Corporate Credit Rating? and Corporate Bonds: An Introduction To Credit Risk), time, tax considerations (particularly in the U.S.) and convertibility of the particular loan.
Risk refers to the likelihood of the loan being repaid. The bigger the chance of the loan not being repaid will lead to higher interest rate levels. If, however, the loan is "secured", meaning there is some sort of collateral that the lender will acquire in case the loan is not paid back (i.e. such as a car or a house), the rate of interest will probably be lower. This is because the risk factor is accounted for by the collateral.
For government-issued debt securities, there is of course very little risk because the borrower is the government. For this reason and because the interest is tax-free, the rate on treasury securities tends to be relatively low.
Time is also a factor of risk. Long-term loans have a greater chance of not being repaid because there is more time for adversity that leads to default. Also, the face value of a long-term loan, compared to that of a short-term loan, is more vulnerable to the effects of inflation. Therefore, the longer the borrower has to repay the loan, the more interest the lender should receive.
Finally, some loans that can be converted back into money quickly will lose little if any loss on the principal loaned out. These loans usually carry relatively lower interest rates.
As interest rates are a major factor of the income you can earn by lending money, of bond pricing,and of the amount you will have to pay to borrow money, it is important you understand how prevailing interest rates change: primarily by the forces of supply and demand, which are also affected by inflation and monetary policy.
Of course, when you are deciding on investing in a debt security, it is important you understand how its characteristics determine what kind of interest rate you can receive.