The Link Between Interest Rates and Stock Prices
Why the Fed's rate cut led to an S&P500 jump
The S&P5001 reached a new all-time-high last week following the Federal Reserve’s (Fed) decision to cut its policy interest rate by 50 basis points - or 0.50% - the first cut in 4 years.
And everyone is writing about it, including my favorite publication - The Financial Times.
Why does a change in the Fed’s rate impact the stock market?
I love economics and how all the different macro and micro elements influence each other. Last week showcased such a great interplay, which compelled me to explain how it all links together.
It all starts with interest rates and central bank monetary policy
Interest rates indicate the cost of borrowing - the rate at which banks and businesses borrow - think of this as the cost of money going around (it’s either the cost you pay to borrow money from the bank or the opportunity cost you pay for not depositing your money with the bank).
Interest rates are a mechanism used by central banks to influence the economy. When too much money goes around, inflation is pushed up and, although some inflation is a positive sign of economic growth, we don't want too much inflation - because it erodes purchasing power and could destabilize the economy.
But too little economic growth is also not good. The US economy started signaling a slowdown, including a decline in GDP growth (economic growth), a drop in consumer spending, and a slowdown in job creation. Additional factors such as fears of weakening global demand, compounded by trade tensions, also prompted the Fed to act in order to prevent a deeper economic contraction. These indicators prompted the Fed to intervene before the US economy slowed down too much, aiming to stimulate growth and prevent a deeper contraction.
Interest rate cycles
The image above shows the Fed’s target rate since 2000 - it shows how interest rates move in cycles (or waves) and - as can be seen - currently, interest rates are on the higher end of the cycle, and with high interest rates, money is expensive - because borrowing is expensive for consumers and business - so spending slows down, inflation comes down and job creation slows down. Too much slowing down could lead to a recession so the central bank needs to intervene to ensure the economy stays alive - and how do they do this? By lowering interest rates, the central banks make money cheaper.
Cheaper money flows through to the economy and ultimately impacts stock prices in three ways:
Interest rates feed through to business loans and consumer credit. And if it’s cheaper to borrow money, more money gets spent by businesses and consumers.
When interest rates are lower, borrowing is cheaper and businesses pay less in financing costs for their debt - this means more profits for businesses.
With interest rates down, fixed-income investments (for example, savings accounts and bonds) are less attractive and make investors move to investments such as stocks that have higher expected returns (but with more relative risk).
All these lead to more spending, growth, profits, and ultimately higher stock prices.
But does the stock market not price this in?
Analysts expected a rate cut. As soon as the economy shows signs of cooling down (GDP growth, jobs etc), a rate cut becomes more likely and this gets priced into the stock market - but exactly how much the cut will be is uncertain. A 0.50% cut is big and therefore more than the majority of market analysts expected. This “big” cut had a positive impact because of the additional growth impact it is expected to have.
It’s not about the news but rather how reality compares to expectation
It is very important to remember that stock market reactions are never about the news, but about how the news compares to what was expected. In simple terms: If the news is better than expected then the market moves upwards, if worse than expected then the market moves downwards.
Here’s a short, fun video I made on Instagram to explain this better:
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The S&P500 is an index which tracks the 500 largest public companies in the US, the biggest stock market in the world