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How Do Interest Rates Affect Stock Prices?

September 19, 2016

This week, Janet Yellen and other members of the Federal Reserve (the Fed) will meet to discuss, among other things, interest rates. Much debate is currently being had as to when the Fed will decide to raise rates, and by how much. So I thought it might be a good time to discuss how interest rates can impact stock prices.

 

Interest rates impart a force in the financial world similar to gravity’s downward pull in the physical world. All other factors being equal, higher interest rates tend to depress market prices for stocks and other investment assets, while lower rates tend to push market prices up.

 

Besides stock prices, interest rates also impact prices for real estate, bonds, farmland, etc. Theoretically, prices for all types of income-producing assets are affected by interest rates. The reason, in short, is because interest rates represent opportunity cost. An increase or decrease in the going rate of interest changes the relative attractiveness, and hence the price, of all alternative investments.

 

Today, an interesting phenomenon seems to be occurring. Interest rates have fallen to ultra-low levels (even negative in some cases). One would expect that lower interest rates would tend to push stock prices upward, but so far this expected jump has not occurred, or at least has not occurred fully. Gravity is being defied. Why is that? I tend to think it is because the market does not expect rates to stay this low forever.

 

To restore equilibrium between the stock market and interest rates, two things could happen. Stock prices could rise, or interest rates could rise. One or the other (or a combination of both) must happen in order to return balance to the financial world.

 

Here’s my disclaimer: interest rates are a complicated topic, and the above comments only begin to scratch the surface. I do not know how to predict changes in interest rates. As such, I do not base investment decisions on what I think the Fed or anyone else will do to affect interest rates. The best investments are those that can win in any interest rate environment.

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