How Do Interest Rates Affect the Stock Market?

Recently, in a meeting held on August 8, 2024, RBI decided to keep interest rates unchanged at 6.5%. Following this, several banks like Canara Bank, Bank of Baroda, and UCO Bank raised their lending rates. This implies that borrowing money, whether for personal loans, home loans, or business loans, will now be more expensive. This adjustment will now directly impact customers and lead to higher interest payments.

Now, stock market investors must note that interest rates and stock market performance are closely connected. When interest rates rise, borrowing becomes expensive for companies. This reduces their profits and consequently lowers stock prices. Also, it makes bonds and savings more attractive than stocks. On the other hand, lower interest rates make borrowing cheaper and boost stock prices.

For more clarity, we have covered five different ways in which changes in interest rates affect the stock market and investor confidence. We will also understand the relationship between these rate changes and bond yields.

• Rising interest rates affect the stock market by making borrowing more expensive. This reduces company profits and lowers stock prices.
• Higher interest rates encourage investors to shift to safer options like bonds. This also reduces demand for stocks and pushes stock prices down.
• Financial institutions, like banks and NBFCs, benefit from higher interest rates as they can charge more for loans. This boosts their profitability and stock prices.

Interest rates and stock prices usually move in opposite directions. When interest rates rise, stock prices fall, and vice versa. This primarily happens because of these five top reasons:

1. Cost of borrowing

When interest rates rise, companies have to pay more to borrow money. This increases their costs and, in turn, reduces profits. When profits go down, investors get discouraged and are unwilling to pay high prices for company stocks. Generally, this leads to a drop in stock prices.
 

On the other hand, lower rates make borrowing cheaper. This lowers the cost of production for companies and boosts their profits. Ultimately, this creates positive market sentiment and leads to an increase in stock prices.
 

2. Consumer spending

Higher interest rates also affect consumers. When it becomes more expensive to take loans or use credit, people usually spend less on goods and services. This reduction in spending hurts companies and lowers their sales. This effect is felt even more by companies that sell consumer products.

Mostly, lower sales translate into less profit and as profits decrease, the stock prices of these companies also fall.
 

3. Economic growth

Numerous studies have shown that rising interest rates affect the stock market by slowing down economic growth. When borrowing becomes expensive, both businesses and consumers cut back on spending, which slows down overall economic activity.

This slowdown negatively impacts corporate earnings and leads to lower stock valuations and stock prices.
 

4. Alternative investments

Higher interest rates affect the stock market by making alternatives like bonds or savings accounts more attractive because they offer “safer returns”. In such a situation, several investors prefer selling off stocks and moving their money to these safer options.

This shift in investment preferences results in lower demand for stocks, which, again, pushes stock prices down.
 

5. Impact on financial institutions

Generally, banks and other financial institutions benefit from higher interest rates. That’s because they can now charge more for loans and improve their “net interest income”. This situation improves their profitability and also boosts their stock prices.

Here, we can observe that, unlike other sectors, financial institutions can perform better when rates increase.

As per a thumb rule, interest rates and bond yields move in opposite directions. When interest rates rise, new bonds offer higher yields (returns). This makes older bonds with lower yields less attractive. As a result, the prices of those existing bonds drop because now investors prefer new bonds with better returns.

On the other hand, when interest rates fall, older bonds that provide higher returns/ yields become more valuable, so their prices rise. This inverse relationship is especially noticeable in long-term bonds, which are more sensitive to changes in interest rates due to their longer duration.