That boring headline on newspapers or news channels about ‘interest rate’ barely manages to catch the attention of those who are not much into investing. However, it means a lot to investors. We will see here how interest rates affect the stock market and investors.
WHAT IS INTEREST RATE?
Simply put, it is the rate (or percentage) at which a lender lends money to the borrower. However, in this context, it refers to the rate at which the Central Bank of a country lends money to Commercial Banks. It is a way of controlling the money supply in the economy.
We will not dive deep into all the factors that determine the effectiveness of this method, since it could be a topic on its own. There are also a myriad of interest rates that the central bank controls, like reverse repo rate. But to keep things simple for the average reader, we have immensely simplified the country tent to explain the processes.
Changes in interest rates cause a ripple effect in the economy. If interest rates are set lower, the commercial banks have to borrow at a lower rate and therefore they are likely to keep the interest rates low for the public that borrows from them. In this scenario, more people will start borrowing and this will lead to the increased spending capacity of people. The economy is expected to see a rise in expenditure on capital assets like stocks. An increase in its demand will pull the price up for many stocks thereby creating a temporary bullish market.
On the contrary, when the interest rates are increased by the central bank, the commercial banks will be forced to borrow at higher rates. This means public will likely get credit at a cheaper rate and hence people’s spending capacity will not see any positive changes. Stock prices will likely decrease because of lower demand.
WHY IT MATTERS TO INVESTORS
When interest rates are increased, stock prices usually come down. Value investors will usually not make a major move at this point. Short sellers will probably flock to the stock market to take advantage of the temporary dip in prices.
However, when interest rates are slashed, it usually leads to increase in stock prices to which short-sellers react by selling quick.