Investing News Blog Reader Question: What Do Interest Rates Have To Do With the Stock Market?
I encourage reader questions here at the Banks.com investing blog, and I am excited to answer the first question I have received:
There is big news about a Fed rate cut later today [March 18, 2008], and how investors are getting excited about it. It doesn’t seem to have a real connection in my mind. What do interest rates have to do with the stock market?
Yes, the Fed rate cut yesterday resulted in a stock market rally. Directly, interest rates have very little to do with the stock market. However, there are immense psychological and chain-reaction effects between interest rates and the stock market.
Lower interest rates make borrowing less expensive
Just as lower interest rates help your variable credit card rate drop, the cost of borrowing for businesses goes down as well. This means that it is possible for growing companies to borrow money for expansion more cheaply. This means that there could be more capital leftover in the company, or it could mean that the company can finance more. Either way, it is seen as a way to increase future earnings and profits. And that means higher stock prices.
Lower interest rates lead to more investing in the stock market
Investors use different instruments to make money. One of these are bonds, which allow investors to make money from interest. Lower interest rates mean that bonds are less profitable for investors, so they are more likely to shift their investing dollars into the stock market. This increased demand lifts stock prices.
As mentioned before, these are not direct effects. Lower interest rates merely set off a certain line of thinking that (usually) leads to gains on the stock market. It’s mostly psychological, as many investors see it as beneficial to the economy. And, as we have seen in recent months, group psychology often leads to very real-world consequences.
Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional.
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