How Interest Rates Affect the U.S. Markets

Changes in interest rates can have both positive and negative effects on the markets for stocks and bonds. Stock and bond investors are alert to changes in the behavior of consumers and businesses in the wider world, and interest rate changes affect that behavior.

For stock investors, higher interest rates mean cutbacks in spending. Lower interest rates encourage big purchases by consumers and expansion by businesses. Those changes feed back into corporate profits, for better or worse.

For bond investors, higher interest rates mean higher rates on new bond issues but a decline in the values of existing bonds. Lower interest rates have the opposite effects: New bond issues offer less interest while existing bonds trade at a premium.

Understanding the relationship between interest rates and markets can help investors make better financial decisions.

The All-Important Fed Funds Rate

The Federal Reserve, the nation's central bank, changes its target interest rates to keep the economy at a healthy rate of growth. It raises rates when the economy is too hot, threatening to raise inflation. It lowers rates when the economy is sluggish to boost activity to a healthy level.

The Fed manipulates overall interest rates by raising or lowering the federal funds rate. This is the rate at which banks borrow and lend money to one another short term to maintain a reasonable balance of cash in their vaults.

The change in the federal funds rate ripples through the economy, changing rates for everything from auto loans to business borrowing. It usually takes at least 12 months for the change to have a widespread economic impact, but the stock market's response is often more immediate.

The Discount Rate

In addition to the federal funds rate, the Federal Reserve sets the discount rate. That is the interest rate the Fed itself charges banks that borrow from it directly. This rate tends to be higher than the target federal funds rate.

The interest rate that impacts the stock market is the federal funds rate. This is the rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans.

The Money Supply

The Federal Reserve changes the federal funds rate to discourage inflation. By increasing the federal funds rate, the Federal Reserve is effectively shrinking the supply of money available for borrowing.

When the Federal Reserve decreases the federal funds rate, it increases the money supply. This encourages spending by making it cheaper to borrow.

How Interest Rates Affect Spending

The credit system exists so that borrowers can spend money immediately instead of waiting to save enough money to make a purchase. The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses and cars.

When consumers pay less in interest, they are more willing to spend and they're willing to spend more. This creates a ripple effect of increased spending throughout the economy.

How Business Spending Changes

Businesses and farmers also benefit from lower interest rates. It encourages them to make large equipment purchases or even expand into new areas due to the low cost of borrowing.

Overall, this creates a cycle in which economic output and productivity increase.

Higher interest rates force consumers to cut back on spending. Banks toughen their standards as well, making fewer loans.

Inevitably, this affects the bottom line of many businesses.

Impact on Stocks

When interest rates rise, it also makes it more expensive for companies to raise capital. They will have to pay higher interest rates on the bonds they issue, for example.

Making it more costly to raise capital can hurt the company's future growth prospects as well as its near-term earnings. The result could be a revision downward in profit expectations going forward as rates increase.

If a company is seen as cutting back on its growth or is less profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop.

All else being equal, this will lower the price of the company's stock.

Winning and Losing Sectors

If enough companies experience declines in their stock prices, the whole market, or the key indexes many equate with the market—the Dow Jones Industrial Average and S&P 500—will go down.

With lowered expectations for company growth and future cash flows, investors will not get as much growth from stock price appreciation. Moreover, investing in stocks can be viewed as too risky when compared to other investments.

Nevertheless, some sectors benefit from interest rate hikes. One sector 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 money.

Otherwise, some stocks will do better than others as interest rates increase. Consumer staples like soap and cereal will still sell pretty much as usual. Luxury cars maybe not so much.

Impact on Bonds

Interest rates also affect bond prices. There is an inverse relationship between bond prices and interest rates, meaning that as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise.

The reason for this is quite straightforward. Say a bond with a $1,000 face value pays 5% interest annually ($50 per year) at a fixed interest rate. It is issued when prevailing interest rates are also 5%.

A year later, interest rates increase to 10%. A bond investor can now buy a new bond for $1,000 and be paid $100 per year for holding it.

This means that the old bond, which pays only $50 per year, has to be worth less. The only way somebody would buy the 5% bond would be at a discount in the bond market.

Now say interest rates instead fall to 1%. A new bond purchased for $1,000 would only pay $10 per year to bondholders. The old one that pays $50 is now very attractive, and the market will bid this up so that it trades at a premium in the market.

Opportunities for Bond Investors

For income-oriented investors, a reduction in the federal funds rate means a decreased opportunity to earn money in interest. Newly issued bonds, including U.S. Treasury bonds, will pay less.

Moreover, a decrease in interest rates will prompt investors to move money from the bond market to the equity market in hopes of greater opportunities. The influx of new capital instead can cause the stock markets to rise. 

The reverse is true, of course, when interest rates rise. Newly issued bonds will pay better interest although, as noted below, the values of existing bonds will decrease.

How Interest Rates Affect Inflation and Recession

Inflation is the increase in the price of goods and services over time. To some degree, it is the direct result of a strong and healthy economy. However, if inflation is left unchecked, it can lead to a significant loss of purchasing power.

The Fed watches inflation indicators such as the Consumer Price Index (CPI) and the Producer Price Index (PPI). When these indicators start to rise more than 2% to 3% a year, the Fed will raise the federal funds rate to keep rising prices under control.

Because higher interest rates mean higher borrowing costs, people will eventually start spending less. The demand for goods and services will then drop, which will cause inflation to fall. 

A notorious example of this occurred between 1980 and 1981. Inflation was at 14% and the Fed raised interest rates to 19%. This caused a severe recession, but it did put an end to the spiraling rate of inflation.

More recently, in 2022 through the middle of 2023, the Fed steadily increased rates to temper inflation largely caused by the COVID-19 pandemic.

The Effect of Expectations

Rising or falling interest rates affect consumer and business psychology. When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

The change can be felt before it even happens. Well before the Federal Reserve announces an increase, businesses and consumers may anticipate the change and cut back on spending. This can cause earnings to fall and stock prices to drop, and the market may tumble in anticipation.

On the other hand, if people expect that the Federal Reserve will announce a rate cut, consumers and businesses will increase spending and investment. This can cause stock prices to rise.

Stock traders like to anticipate an event, not react after it happens.

The Bottom Line

Changes in interest rates broadly influence stock prices, bond interest rates, consumer and business spending, and the state of the overall economy.

However, there is often a time lag between an interest rate change and its effect on the economy. Some sectors react quickly, such as the stock market, while the effect on mortgages and auto loans can take longer to be seen.

By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow investors to understand the big picture and make better investment decisions.