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How do interest rates affect stocks?

How do interest rates affect stocks?

If you keep tabs on your bank accounts, mortgage or credit card bills, or investing accounts, you probably have heard of the word interest. Maybe you even know a thing or two about interest – like it’s the money you are paid by a bank or pay to a lender for services. It’s everywhere, so it shouldn’t surprise you to hear that interest rates affect every part of the financial system.

Unless you pursued a degree in economics, it’s probably fair to assume your education experience didn’t acquaint you with the finer points of how interest rates work. For that reason, we’re breaking down how interest rates affect stocks and what you need to know:

What is Monetary Policy?

If you’ve ever taken a U.S. government class, you’ve probably heard the expression that “there are three branches of government.” However, it is also argued that there are four branches: the executive, the legislative, the judiciary, and the Federal Reserve. The latter might be considered the most powerful of the four because it’s mostly free from the influence of the other three branches. It also happens to be in charge of something called monetary policy.

Monetary policy is responsible for stimulating the economy – maximizing employment, managing inflation, and generating economic growth. The way that the Federal Reserve achieves these goals is by managing the relationship between two interconnected factors: interest rates and the printing of money. At a very basic level, this relationship is affected by the Fed printing money and buying bonds in the bond market to artificially reduce the rates. 

When the economy is not doing too hot or needs a boost (like, during a recession caused by a giant pandemic), the Fed will generally decide to lower interest rates. They’ll set a target rate and then meet it by printing money to buy lots of bonds. The benefit of lowering interest rates is that it encourages people to invest. However, printing money and keeping interest rates low forever is not a traditionally accepted method for running a central bank. 

Eventually, the Federal Reserve is supposed to slow its investment in bonds – allowing the bond market to return to normal supply-demand behavior. This causes rates to rise and allows money to be taken out of the economy through something called quantitative tightening. However, this has rarely happened in practice for the last three decades. Instead, interest rates have remained relatively low and the money supply has expanded.

Low interest rates are great for the economy, since this encourages people and companies to spend or borrow new equipment, hire employees, and make other investments. For everyday Americans, low interest rates disincentivizes saving. Since low interest rates have been a consistent theme for the last 10 years, saving in your bank account is simply not enough anymore.

This sets up our discussion about monetary policy and the stock market in 2021.

What do interest rates have to do with stocks in 2021?

As concerns about the COVID-19 pandemic rippled throughout the global economy in February 2020, the Federal Reserve dropped interest rates to zero to mitigate an economic disaster. They also announced a $700 billion quantitative easing program to buy assets. Regardless, the stock market crashed. The unprecedented circumstances prompted the government to launch an aggressive stimulus campaign … and then another, and another.

The perfect storm of rock-bottom interest rates, three stimulus campaigns, and money printing caused the price of assets to rise aggressively. Housing prices, cryptocurrencies, and stocks went to all-time highs. This began to prompt concern among investors about inflation. Inflation refers to the general increase in price of goods over time, which devalues money. However, inflation can also happen if the amount of money expands faster than the economy allows. 

A year out from the pandemic, the conversation around interest rates, asset prices, and inflation is at center stage. The Federal Reserve insists that it still has a long road ahead of itself to reach its employment, economic growth, and inflation goals. It also underscores that it has no plans of raising interest rates until it reaches some of those goals – which means no rise in interest rates through at least 2023. Despite this, bond traders don’t believe the Fed – they estimate that a robust recovery will certainly mean rising rates and inflation before then.

The result is yield-sensitive assets getting hammered. 

Certain assets are going to be more affected if rates rise. Technology stocks and growth stocks are among the most hard-hit in early 2021. However, all assets prices should theoretically fall when interest rates rise. As a result, it’s easy to understand why the market has turned red in response to the bond market’s fears. The stock market will be dictated by the bond market’s fear. However, in the case that bond traders are actually wrong and the Federal Reserve keeps true to its promise to keep rates at zero, stocks will have ample room to rally.

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