Who is in charge of determining the interest rate in the US? It’s the Federal Open Market Committee (FOMC or the Fed). For some parts of the economy, the effects of changing interest rates won’t be felt for a few months, maybe even a year. The effects are felt momentarily for other parts of the economy, such as borrowing and investing. This year, inflation is soaring. It hasn’t been this high since the ’80s. Generally, interest rates increase during periods of high inflation. Different market conditions have different effects on the economy. In today’s article, we will see if there is a correlation between a rise or a fall in interest rates and the stock market performance. We will also examine the effects of higher and lower interest rates on the rest of the economy.
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How Interest Rates Affect the Economy
In this article, we won’t understand the theory behind interest rate changes. Monetarists and Keynesians have their points of view, and they can remain in your Econ class. Instead, we will focus on their effects on the economy as a whole. Even if you don’t invest in the stock market, a rise or a fall in interest rates affects your daily life. Here’s how.
What Happens When Interest Rates Fall?
In theory, when interest rates fall, it signals growth. The government wants to stimulate the economy. It becomes much cheaper to borrow funds at a financial institution.
Now’s the time for consumers to refinance their mortgage, get a car loan or borrow funds for an eventual expense. What does it mean for corporations?
It is also cheaper for them to grow their business. As a result, unemployment decreases, and the economy grows. As for the stock market, it is also a good period to invest. Financial institutions decrease interest rates for savings accounts, making bonds less attractive. Ultimately, stocks usually gain momentum, and investors are happy. During this period, it’s better to invest in growth stocks and riskier assets.
What Happens When Interest Rates Increase?
When interest rates increase, the panic begins. It is the case today due to high inflation levels. Those with a variable-rate loan or mortgage can immediately feel the consequences.
Fixed terms remain unchanged. It becomes more expensive to borrow new funds. Less money in our pockets means less money in the stock market.
Investors usually opt for safer investments such as bonds and interest rates since their rates become much more attractive in the short term. However, businesses also feel the change as customers are less likely to spend money. As a result, revenues are down, and company financials are affected.
Financial institutions and defensive stocks tend to perform well during this period. Consumer and industrial goods also tend to perform well.
On the other hand, investors should stay away from growth stocks and riskier investments. In the next section, we will look at the immediate effects of rising interest rates on the US stock market. Does it automatically signal a fall in stock prices, or do markets remain stable? Let’s find out.
Historical Impact of Interest Rate Changes on the Stock Market
Historically, stock market indexes such as the DJIA, S&P 500, and NASDAQ increase when interest rates increase. One of the main reasons is that the stocks included in these indexes have strong financials and balance sheets. As a result, these companies continue to grow despite market conditions not being ideal. Let’s look at various periods in detail since the beginning of the ’90s.
Interest Rate Decrease
5/31/1989 – 2/3/1994: After six years of economic expansion, the US fell into a recession in July 1990. It lasted eight months. The Fed lowered interest rates to stimulate growth. During this period, the DJIA gained 60%, the S&P 500 gained 50%, and NASDAQ gained 78.8%.
7/5/1995 – 3/24/1997: The DJIA gained 49.6%, the S&P 500 gained 44.5% and NASDAQ gained 31.9%.
9/28/1998 – 6/29/1999: DJIA: +33.4%, S&P 500: +28.9%, NASDAQ: +51.9%
1/2/2001 – 6/29/2004: In 2001, the Fed lowered interest rates at an unprecedented level from 6% to 3.5%. We haven’t seen such rates since. After the 9/11 attacks, rates continued to decrease. In 2003, they reached 1% and remained at that level for some time. As for bonds, 1-year yields fell to 1%, but 10-year yields were 3% higher. During this period, many investors chose bonds over stocks.
DJIA: -2.2%, S&P 500:-11.5%, NASDAQ: -11.2%
9/17/2007 – 12/15/2008: Just a recession with a slow recovery, no big deal.
DJIA: -36.1%, S&P 500:-41.2%, NASDAQ:-41.6%
7/31/2019 – 1/14/2022: Interest rates for bonds and savings accounts are no longer attractive. Investors turn themselves to the stock market for gains.
DJIA: +33.5%, S&P 500: +56.2%, NASDAQ: +81.9%
As we can see, decreasing interest rates works wonders for the economy. Except for the instance of the worst recession since the Great Depression. Will the opposite happen when rates increase?
Interest Rate Increase
2/3/1994 – 7/5/1995: The interest rates increased seven times during this period. SEVEN! This was a preventive measure due to a long period of economic growth. Despite 1-year treasury bonds reaching a high of 7.32% in January 2015, major indexes were unfazed.
DJIA: +16.3%, S&P 500: +13.8%, NASDAQ: +18.1%
3/24/1997 – 9/28/1998: DJIA: +17.4%, S&P 500: +32.6%, NASDAQ: +40%
6/29/1999 – 1/2/2001: Following the Dot Com bubble, rates were increased to stop inflation and reset the economy.
DJIA: -1.6%, S&P 500: -5%, NASDAQ: -13.3%
6/29/2004 – 9/17/2007: DJIA: +28.7%, S&P 500: +30%, NASDAQ: +26.9%
12/15/2008 – 7/31/2019: After the Great Recession, interest rates remained stable at just over 0% and slowly increased towards 1%. Nothing dramatic. Major indexes benefitted and grew.
DJIA: +213.7%, S&P 500: +243.1%, NASDAQ: +442%
Today: On Monday, July 13th, major indexes and stocks in the US fell. Many anticipated a 0.5% to 0.75% interest hike by the end of the month. On Wednesday, inflation was announced at 9.1%. An interest rate hike was expected from the markets due to a rising inflation figure. Who knows what the rest of 2022 has in store for us?
If we can conclude one thing from the figures above, it is that regardless of the interest rate movement, investing in the DJIA, S&P, or NASDAQ indexes is a safe bet. The NASDAQ composite index is much more volatile due to overpriced tech stocks. On the other hand, growth stocks are much more vulnerable to unstable market conditions. Unfortunately, there isn’t a clear correlation between interest rate movements and the stock market.
Interest Rates and the Stock Market Conclusion
To conclude, stock market conditions have evolved over the years. As a result, it is becoming more and more difficult to predict the future based on past events. However, we can conclude one thing when we look at the historical returns of major indexes such as the DJIA, S&P 500, and NASDAQ during increasing and decreasing interest rates. Keep your money in those indexes no matter what. They provide constant returns no matter the interest rate. Investing in stocks that aren’t in those indexes is much more challenging and requires more knowledge. Thankfully, we can help.
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