How Interest rates affect stock prices – I

This article is based upon the request from Bhavik (left in my previous article on Financial/ Investment Projects failure, who has asked for explaining how the interest rate changes affect the stock market prices.

How do the interest rates affect the stock prices?

As I’ve explained in my previous articles, people invest money in different instruments for the sake of getting good returns. As a matter of fact, there are 2 aspects of investments. One is the return, other is the risk or loss. (For the moment, we’ll leave aside the third aspect namely, transaction costs).

Individuals have a psychological bias – they want MORE returns and LESS risk. To put it in simple words, they want to MAXIMIZE returns and MINIMIZE risks.

Hence, the investors look for investment products which give them better returns and leave them with less risk. A savings bank account is an investment product which gives you assured returns. So is the stock investment. However, the major difference between the 2 is that one is considered risk-free while other is full of uncertain risk.

Now, in case the interest rates are high, say 8% or 10%, the investors would love to put their money in the bank accounts – which are considered very safe – no risk at all. Though the stock markets have had a fantastic run in the last 6 years, it is a fact that stock market returns in the range of 10-15% have been considered extremely good. So, investors who can get around 10% returns risk free in savings bank account, would like to save money in bank accounts, instead of putting it in the risky stock market. Hence, the stock market investments go down when the interest rates are higher.

Any government bodies, like Fed in US or RBI in India, are the regulatory authorities which deal with interest rates. Since they are government bodies, they have the power to change the interest rates anytime as per the economic conditions or market requirements.

Also, the interest rates defined by them, become the benchmark for different types of loans. Hence if the Fed says that interest rate is 5%, it is possible that other loans like home loan, car loan, personal loan, education loan will all be charged an interest rate dependent upon the interest rate determined by Fed or RBI. Typically, house loan may be 2.5% higher than the Feb interest rate, hence it will become 7.5%, car loan may be 4% higher than Feb interest rate, hence it will become 9% and so on. So whenever there is a interest rate change by the regulatory authorities, the bank as well as loan market goes for a complete revamp.

Effectively, when the Fed cuts the interest rates, as it has done recently from 5.25% to 4.75%, it is done to reduce savings and increase expenditure. Since the rate has gone down, it will also reduce the other loan interest rates. Hence buying a house may become cheaper in US, and so will be taking a car loan, education loan, personal loan, etc.

Another effect that happens is that such rate cut also brings down savings and introduces liquidity in the market. Since the rate has gone down, the savings accounts will no longer earn higher interest rates. Hence the risk- free returns will come down. Therefore, investors will now switch their money from bank accounts to stock market investments. Hence, the result of a rate cut is that there is a big switch from safe investments to stocks, which causes huge demand of stocks; therefore the stock markets go up due to a fed rate cut.

Continue to Part II of this article