Stocks vs Interest Rates: How Interest Rates Affect the Stock Market
This is a beginners guide to stocks and interest rates, why they are related, and how interest rates can affect stocks. If you'd rather watch a short YouTube video explanation click here or the thumbnail below.
So in order to understand how interest rates affect stocks we first need to understand why the two are even tied together in the first place, and that brings us to something called a balanced portfolio. Generally investment banks, hedge funds, and portfolios that are put together by financial advisors are made up of a portion of stocks and a portion of bonds. Since bonds are usually considered safer investments they tend to make up the bulk of portfolios for people closer to retirement of investors just looking to take a more conservative approach. On the other hand, younger investors or those who want to be more aggressive tend to keep more of their money in stocks with the intention of getting a higher return while theoretically taking on more risk. Although this balance is also governed by interest rates
Interest rates affect the return that investors make on bonds. The higher the interest rate, the more money you make, the lower the interest rate the less money you make. This means that if interest rates rise then bonds become more attractive. This causes investment banks, hedge funds, and other investors to shift more of their money into bonds because now they can make a higher return on a safer investment so it makes sense to reduce some of their risk to stocks. In order to do this they have to sell stocks and buy bonds. This selling pressure pushes stocks down, and so generally when interest rates rise stocks fall.
When interest rates fall the opposite is true. When this happens, bonds become less attractive so investors shift their money into stocks. The buying pressure caused by this shift pushes stocks up. This shift can also be exaggerated by inflation. If inflation is high, then investors will look for ways to increase their returns. Bonds generally offer lower returns, so investors will often shift money into stocks as inflation rises.
So in simple terms this is the relationship between stocks and interest rates, and how interest rates can affect stocks. As a general rule of thumb, when interest rates rise stocks will fall, and when interest rates fall stocks will rise. If you found this explanation helpful please consider subscribing to the blog or YouTube channel for more stock market information and analysis. Have a great day!