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October 10, 2017

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How Interest Rate Increases Affect the Stock Market

October 10, 2017

With global markets enjoying a relatively peaceful spell over the summer, attention has turned recently to the actions of the US Federal Reserve and the Bank of England. US interest rates have been raised twice this year already, in March and June, and while the Fed voted to leave interest rates unchanged this month, the central bank advised that it expects to raise borrowing costs one more time this year. According to the CME Fedwatch tool, markets currently price in a 70.5% chance of an interest rate hike in December.

In the UK, the Bank of England recently announced that it may raise UK rates “over the coming months.” UK interest rates were lowered to 0.50% in March 2009 after the Global Financial Crisis, and were held at this rate until August last year, when they were lowered even further, to 0.25%, in the wake of the UK’s decision to leave the European Union. However, the Bank of England is now concerned that inflation is rising, and has advised that it may raise interest rates as a result.  

So with two key markets, the US and the UK, potentially facing higher interest rates, what are the implications for the stock market?

Inverse relationship

Donald Trump defiantly stated last year during his presidential debate with Hillary Clinton: “The only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down.”

Is he right?

In theory, there should be an inverse relationship between interest rates and stocks. There’s several reasons why.

The first is that a rise in interest rates makes borrowing more expensive. Increased borrowing costs erode company profitability, and given that stock prices are related to profitability, stock prices should in theory decrease if rates rise. Of course, this will affect some industries more than others. For example, due to the capital intensive nature of the utilities industry, many utilities companies operate with high levels of debt. As interest rates rise, this debt becomes more difficult to service, detracting from the bottom line. However, in contrast, financial services companies such as banks can benefit from an interest rate rise, as higher rates allow them to earn a greater spread between the funds they borrow and the funds they lend out.

In further support of an inverse relationship between interest rates and stocks is the idea that as the risk-free interest rate rises, and the yields on government bonds and bank savings accounts increase, risky assets such as stocks and corporate bonds should in theory become less attractive. For instance, a 2.0% dividend yield on a stock may become less attractive, if savings accounts are paying a higher rate of interest.

 


How markets have performed in reality

However, before you go and sell your stock portfolio, it’s worth taking a look at what has actually happened in the recent past when interest rates have been increased. In reality, interest rates and the stock market can trend in the same direction for long periods of time, simply because the conditions that lead to higher interest rates, are also conducive to growth and stock price increases.

For example, between June 2004 and June 2006, the Fed raised interest rates 17 consecutive times, from 1.00% to 5.25%. How did the S&P 500 index perform in that time? It rose approximately 12%.

Similarly, in the UK, the Bank of England increased interest rates five times between August 2006 and July 2007, from 4.50% to 5.75%. How did the FTSE 100 index perform? The UK’s key index rose approximately 13% in that time.

These figures suggest that the theories in relation to how interest rates affect the stock market are not always correct. Recent data challenges the assertion that interest rate increases will negatively affect stock prices.

As a result, investors would be wise to stick to their long-term investment strategies and not get distracted by movements in interest rates.
 
Sources:
https://www.federalreserve.gov/monetarypolicy/openmarket.htm

http://www.bankofengland.co.uk

 

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