Many people may not properly understand how interest rates can affect the stock market and the indirect linkages between them. In essence, interest is the cost that someone pays for using someone else’s money. For the stock market, the interest rate relates to the Federal Reserve’s funds rate. Primarily, this relates to the cost that banks pay for borrowing money from Federal Reserve banks. The rate enables the Federal Reserve to regulate inflation. By influencing the amount of money available for purchasing goods, the Fed can control inflation and this is the practice of central banks in most countries. The Fed is able to decrease the supply of money by virtue of raising the federal funds rate as it makes the money quite expensive. The raise in the federal funds rate has a ripple effect on individuals and businesses while there is a direct effect of making money expensive for the banks to borrow from the Fed.
The effect on stock prices
To understand how the federal funds rate affects the stock markets, let us first take the following example: While valuing a company and its stock, the total of all the expected future cash flows from that company can be taken and discounted back to the present, thereafter divided by the number of outstanding stocks. Based on varied expectations from the company, the final value may vary at different time frames. Accordingly, a decision to buy, hold or sell the stock can be evaluated. In case of reduction in growth spent or no profit being made, the future cash flows may plunge thereby affecting the stock price. Of course, the extent of companies affected will decide the effect on stock market indices as a whole.
There is virtual unanimity in the view that the Fed in the US is going to raise rates sometime this year though this has not yet happened. In fact, the Fed chair Janet Yellin has said that there is likely to be an increase sometime in 2015 and that she agrees with the move. What is likely to influence the decision is the jobs report for September and the progress of the budget debate. The future market is pricing in low odds at 20% on an October rate hike while the odds for December are just under 50%. Other data that will become available in the coming weeks is expected to include personal consumption data as well as the PCE which is the Fed's preferred inflation measure. Whatever be the timing of the hike, investment professionals are confident that the hike will happen only when the Fed is convinced that there has been a strong economic recovery and companies have regained the ability to raise prices. Moreover, history suggests that stocks have done well in periods of rising interest rates and the highest returns have happened when, like today, interest rates have risen gradually during periods of negligible inflation. Other experts have pointed out that there may be a negative impact in the short term, the next 3 to 5 years in the US should see a bull market in which prices will move up beyond the short-term.
A tactical approach to the markets
For investors looking at a tactical approach to the stock markets, there will be some outstanding opportunities as well as some obvious pitfalls in an environment where interest rates are rising. Cyclical sectors of the market will do well particularly financials and regional banks. This is because the stronger US economy necessary to support rising interest rates should help to make lending, consumer spending and household formation to become strong. At the same time, stocks such as utilities and consumer staples could be out of favour because lower growth rates will become less attractive to investors. Moreover, it is likely that income oriented investors will move out of some dividend stocks back into bonds. Another area of concern will be smaller companies which are not well capitalised as the larger ones could be hurt by increasing borrowing costs.
Sectors that will benefit from rising interest rates are banks and insurers because higher rates will boost their net interest margins which are the spreads that they make between their earnings on loans and investments, and what they pay out to customers and claims. However, investors should be selective because some banks will increase their spreads and earnings much faster than others and one major factor in determining this will be the composition of the loan portfolio. For instance, commercial loans generally carry floating interest rates which will rise with the Fed hike. Conversely, rates on mortgages that are fixed for long periods of time are unlikely to benefit. Banks with a higher composition of commercial loans tend to benefit more when rates are raised. Banks with a high proportion of loans to be rolled over within one year will also benefit because they can quickly deploy their money at higher interest rates.
All-in-all, it is to be borne in mind that history still suggests a mixed stock performance post such Fed’s rate hike. For instance, Standard & Poor's 500 stock index dropped on the day when the Fed’s first rate surged three times in 1983. However, there has been a 2.3% rise post first rate hike in January 1987. The future is thus yet to be uncovered depending on the type of rise Fed rate attains.
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