Few things move the stock market as much as interest rates. Announcements from the US Federal Reserve can send stocks sharply higher or lower in minutes. Here's why rates matter and how they affect different kinds of companies.
Who sets interest rates?
The Federal Reserve sets a target for the federal funds rate, the rate banks charge each other for overnight loans. It raises rates to cool the economy and fight inflation, and cuts them to support growth. Market forces set longer-term rates, such as the yield on the 10-year Treasury, which reflect expectations for growth, inflation and future Fed policy.
Three ways rates affect stocks
1. Valuations
A stock's value is the present value of its future cash flows. Higher interest rates mean future cash is discounted more heavily, so it's worth less today. That's why rising rates tend to push valuation multiples, such as the P/E ratio, lower. You can see this effect directly by changing the discount rate in the DCF calculator.
2. Company profits
Higher rates raise borrowing costs for companies and consumers. Companies with heavy debt pay more interest, and spending on homes, cars and big purchases tends to slow. See the debt-to-equity ratio for how to check a company's debt.
3. Competition from safer assets
When savings accounts and bonds pay more, some investors move money out of stocks. When rates are very low, stocks look relatively more attractive. See stocks vs. bonds.
Which stocks are most sensitive?
- Growth stocks: much of their value lies in profits far in the future, so higher discount rates hit them hardest. See growth vs. value.
- Dividend payers and utilities: often compete with bonds for income investors, so they can fall when bond yields rise.
- Real estate and REITs: rely heavily on borrowing. See what is a REIT.
- Banks: can benefit from higher rates through wider lending margins, though sharp moves can also create losses on their bond holdings.
It's about expectations
Markets look ahead, so stocks often react more to changes in expected rates than to the actual decision. A widely expected rate hike may barely move the market, while a surprise in the Fed's outlook can move it a lot.
What investors can do
Trying to trade around Fed decisions is difficult even for professionals. A more reliable approach is to hold a diversified portfolio, favor companies with strong balance sheets, and keep investing steadily through rate cycles. Follow market moves on the StockEngine news page.
This article is educational and not investment advice.
StockEngine articles are for education only and are not investment advice. Some links may be affiliate links.