How Do Interest Rates Affect the Stock Market?

Events since 2020 have highlighted the significant impact of interest rate changes on market behavior. These two forces generally move in opposite directions with rising rates typically causing downward pressure on stock prices. Falling rates tend to boost the market. The relationship isn’t that simple, however.

The Federal Reserve slashed interest rates to near zero in an emergency move to support the economy during the COVID-19 pandemic in early 2020. The Fed aggressively raised rates in 2022 as the economy recovered and inflation surged, pushing them to multi-decade highs to combat rising prices. Then the Federal Reserve cut its influential federal funds rate by 50 basis points in a pivotal shift in September 2024, bringing it to a range from 4.75% to 5%.

This marked the first rate cut in over four years and signaled a change aimed at bolstering economic growth and preventing a rise in unemployment. The stock market’s reactions to these dramatic shifts underscored the sensitive relationship between interest rates and equity valuations.

Interest Rates: An Overview

It usually takes at least 12 months for a change in the interest rate to have a widespread economic impact but the stock market’s response to a change is often more immediate. Markets will often attempt to price in future expectations of rate hikes by the FOMC.

The Federal Reserve also sets a discount rate in addition to the federal funds rate. The discount rate is the interest rate the Fed charges banks that borrow from it directly. This rate tends to be higher than the target federal funds rate, in part to encourage banks to borrow from other banks at the lower federal funds rate.

The federal funds rate is a key driver but other factors such as inflation expectations, economic growth projections, and geopolitical events can also influence how the stock market reacts to interest rate changes.

The Federal Funds Rate

The federal funds rate is the interest rate that impacts the stock market. It’s the interest rate that banks, savings and loans, and credit unions charge each other for overnight loans. The discount rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans to depository institutions, usually overnight.

The Federal Reserve influences the federal funds rate to control inflation. It’s effectively attempting to shrink the supply of money available for making purchases by increasing the federal funds rate. This in turn makes money more expensive to obtain.

Conversely, the Federal Reserve increases the money supply when it decreases the federal funds rate. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns although their specific mandates and tools may differ.

The interest rate that commercial banks charge their most creditworthy customers, referred to as the prime interest rate, is largely based on the federal funds rate. It also forms the basis for mortgage loan rates, credit card annual percentage rates (APRs), and a host of other consumer and business loan rates.

What Happens When Interest Rates Rise?

When the Federal Reserve acts to increase the discount rate, it immediately elevates short-term borrowing costs for financial institutions. This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy.

It costs financial institutions more to borrow money and these same financial institutions often increase the rates they charge their customers to borrow money. Individual consumers are impacted by increases in their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. The amount of money that consumers can spend decreases when the interest rate for credit cards and mortgages increases

Consumers still have to pay their bills. Households are left with less disposable income when those bills become more expensive. Businesses’ revenues and profits decrease when consumers have less discretionary spending money.

Businesses aren’t only impacted by higher borrowing costs when rates rise. They’re also exposed to the adverse effects of flagging consumer demand. Both of these factors can weigh on earnings and stock prices.

The impact of rising rates can vary across sectors, however. Financial institutions may benefit from higher interest rates because they can increase their profit margins on loans.

What Happens When Interest Rates Fall?

The Federal Reserve cuts the federal funds rate to stimulate financial activity when the economy is slowing. A decrease in interest rates by the Federal Reserve has the opposite effect of a rate hike. Investors and economists alike view lower rates as catalysts for growth, a benefit to personal and corporate borrowing. This in turn leads to greater profits and a robust economy.

Consumers will spend more with the lower interest rates making them feel that perhaps they can finally afford to buy that new house or send their kids to a private school. Businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, increasing their future earnings potential. This leads to higher stock prices.

Particular winners of lower federal funds rates are dividend-paying sectors such as utilities and real estate investment trusts. Large companies with stable cash flows and strong balance sheets additionally benefit from cheaper debt financing.

Interest Rates and the Stock Market

The estimated amount of future cash flows will drop if a company is seen as cutting back on its growth or is less profitable either through higher debt expenses or less revenue. This can lower the price of the company’s stock.

The whole market or the key indexes that many people equate with the market such as the Dow Jones Industrial Average and the S&P 500 will go down if enough companies experience declines in their stock prices. Investors won’t get as much growth from stock price appreciation with a lowered expectation in the growth and future cash flows of a company. This can make stock ownership less desirable. Investing in equities can be viewed as too risky when compared to other investments.

Some sectors stand to benefit from interest rate hikes, however. One that tends to benefit the most is the financial industry. Banks, brokerages, mortgage companies, and insurance companies’ earnings often increase as interest rates move higher because they can charge more for lending.

Investors should also be aware of the concept of real interest rates which account for inflation. Real rates could be negative if inflation is rising faster, potentially supporting higher asset valuations even if nominal rates are rising.

Interest Rates and the Bond Market

Interest rates also impact bond prices and the return on certificates of deposit (CDs) as well as Treasury bonds and Treasury bills. There’s an inverse relationship between bond prices and interest rates. Bond prices fall as interest rates rise and vice versa. The longer the maturity of the bond, the more it fluctuates following changes in the interest rate.

Newly offered government securities such as Treasury bills and bonds are often viewed as the safest investments when the Federal Reserve raises the federal funds rate. They’ll usually experience a corresponding increase in interest rates. The risk-free rate of return goes up, making these investments more desirable.

The total return required for investing in stocks also increases as the risk-free rate goes up. Investors may therefore feel that stocks have become too risky and they’ll put their money elsewhere if the required risk premium decreases while the potential return remains the same or dips lower.

One way governments and businesses raise money is through the sale of bonds. The cost of borrowing becomes more expensive for them as interest rates rise, resulting in higher-yielding debt issuances. Market demand for existing, lower-coupon bonds will simultaneously fall, causing their prices to drop and yields to rise.

It conversely becomes easier for entities to borrow money as interest rates fall, resulting in lower-yielding debt issuances. Market demand for existing, higher-coupon bonds will simultaneously increase, causing their prices to rise and yields to fall. Issuers of callable bonds may choose to refinance them and lock in the prevailing lower rates in this type of environment.

A reduction in the federal funds rate means a decreased opportunity for income-oriented investors to make money from interest. Newly issued treasuries and annuities won’t pay as much. A decrease in interest rates will prompt investors to move money from the bond market to the equity market. The influx of new capital causes the equity market to rise.

Impact of Expectations

Rising or falling interest rates can impact the psychology of investors. Businesses and consumers alike will cut back on spending when the Federal Reserve announces a hike. This will cause earnings to fall and stock prices to drop and the market may tumble in anticipation.

The assumption is that consumers and businesses will increase spending and investment when the Federal Reserve announces a cut. This can cause stock prices to rise.

These generalized conventional reactions may not apply if expectations differ significantly from the Federal Reserve’s actions. Suppose the Federal Reserve is expected to cut interest rates by 50 basis points at its next meeting but they instead announce a drop of only 25 basis points. The news may cause stocks to decline because the assumption of a cut of 50 basis points had already been priced into the market. 

The stock market greeted the news by going up in the standard indexes in September 2024 when the Federal Reserve announced a 50 basis point cut and many had expected only 25 basis points.

The business cycle and where the economy is can also affect the market’s reaction. A modest boost provided by lower interest rates at the onset of a weakening economy isn’t enough to offset the loss of economic activity. Stocks may continue to decline. When the Federal Reserve is moving in to raise rates toward the end of a boom cycle in a nod to improved corporate profits, certain sectors often continue to do well. They include technology stocks, growth stocks, and entertainment and recreational company stocks.

The Bottom Line

The relationship between interest rates and the stock market is fairly indirect but the two tend to move in opposite directions. When the Federal Reserve cuts interest rates, it generally causes the stock market to go up. When it raises interest rates, it causes the stock market to go down. There’s no guarantee how the market will react to any given interest rate change, however.

Interest rates are a crucial factor but they’re just one of many elements that influence stock market performance. A diversified investment strategy that takes various economic indicators and personal financial goals into account is often the most robust approach to navigating different interest rate environments.