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The Seesaw Relationship Between Interest Rates and the Stock Market

May 10, 2024



The Seesaw Relationship Between Interest Rates and the Stock Market

In the 2 years plus since the Federal Reserve started hiking interest rates in response to the dramatic increase in inflation, we’ve seen the stock market react in typical fashion. The relationship between interest rates and the stock market is like a seesaw on a playground, reflecting a complex yet predictable interplay. Just as one side of a seesaw rises while the other falls, the stock market often exhibits an inverse reaction to changes in interest rates. I thought it would make sense to briefly explain why that is considering the amount of attention these reactions receive when the Federal Reserve meets.

Interest rates have a significant impact on the stock market for several reasons:


  • Cost of Borrowing: When interest rates rise, borrowing costs for companies increase. This can reduce corporate profits as businesses have to pay more for loans and credit, making it more expensive to finance operations, expansions, or capital expenditures. Conversely, lower interest rates can boost profitability due to lower borrowing costs.

 

  • Valuation Models: Stocks are often valued based on their future cash flows discounted back to their present value. Higher interest rates mean a higher discount rate, which reduces the present value of future cash flows. As a result, stocks can appear overvalued or less attractive compared to when interest rates are low.

 

  • Investor Sentiment and Behavior: Higher interest rates can lead to shifts in investor behavior. When rates rise, safer assets such as bonds or savings accounts become more attractive due to their higher yields, potentially drawing investment away from stocks. This shift can lead to selling pressure in the stock market.

 

  • Economic Impact: Interest rates are a tool used by central banks to manage economic growth and inflation. Higher rates can slow economic growth by making borrowing more expensive, which can dampen consumer spending and corporate investment. This slowdown can, in turn, negatively impact corporate earnings and stock prices. Conversely, lower rates are used to stimulate economic activity.

 

  • Sector Specific Impact: Different sectors react differently to changes in interest rates. For example, sectors like real estate and utilities, which are sensitive to interest rates due to their high levels of debt and reliance on financing, might be more adversely affected by rate hikes.

At Compass Capital Management, we believe that remaining steadfast in focusing on our long-term investment objectives is always the best course of action, and we encourage you to do the same. As always, we appreciate your trust in us to manage your investments. Our relationship with you is paramount, and we are committed to assisting you in achieving your financial goals.