Interest rates and the stock market, easier than you think

It seems difficult to understand the relationship between interest rates and the stock market, as we tend to associate this interaction with a combination of complex factors that go beyond the understanding of anyone. External factors that today show us an uncertain and depressed economy. But what if I told you that the relationship between these two elements is much simpler than we imagine?

Transaction: someone buys what someone else sells

The economy and markets are governed by a basic exchange of goods and services known as a transaction. Millions of transactions occur per minute globally, where some buy what others sell and vice versa. For these transactions to occur, a common and widely accepted means of exchange is needed, money.

Many think that money, in its most basic form, is the cash we have in our bank accounts, but no. Most of the money used to close transactions exists in the form of credit, and this credit money has a cost that is dictated by interest rates. These rates have the greatest impact on the dynamic functioning of markets and the economy.

Federal Reserve Building in the United States

In the United States, the Federal Open Market Committee (FOMC), also known as the Federal Reserve, is responsible for controlling interest rates. These rates are adjusted to speed up or slow down the economy. When the Federal Reserve raises the federal funds target rate, it increases the cost of credit throughout the economy, making loans more expensive, and increasing the cost of paying interest. This slows down investment and at the same time, incentivizes saving cash. This reduces the supply of money in circulation, which tends to reduce inflation and moderate economic activity, i.e., cool down the economy.

When interest rates are adjusted, any impact on the stock market is generally experienced immediately, unlike the rest of the economy, which can take around a year to see a widespread impact. The impact of interest rates tends to affect the stock price of publicly traded companies for two reasons:

• Higher interest rates tend to negatively affect earnings and stock prices (except for the financial sector). This is due to the decrease in consumption, as explained earlier.

• Higher interest rates also mean that discounted future valuations are lower, as the discount rate used for future cash flow is higher.

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