7/19/2022 - Economy and Finance

How do Fed interest rates affect the value market?

By finguru

How do Fed interest rates affect the value market?

Fed in the US rises and lowers the rate and this repercussions in the economy, we explain why.

The investor community and financial means tend to get obsessed with interest rates - the cost someone pays for the use of someone else's money - and for good reasons.

When the FOMC establishes the goal of the federal funds rate, to which banks are indebted and lend themselves, it has a domino effect throughout the US economy, and also in the US stock market. And although it usually takes at least 12 months for any increase or decrease in interest rates to be felt in a widespread economic form, the market response to a change (or news of a potential change) is often more immediate.

Understanding the relationship between interest rates and shareholders markets can help investors understand how changes can affect their investments and how to make better financial decisions.

The interest rate affecting the actions

Market interest rate is the federal fund rate. Also known as an overnight fee, this fee is the one that pays the banks when borrowing money from the federal reserve.

This rate of federal funds is used by the EDF to try to control inflation. Basically, by increasing the federal funds rate, the EDF tries to reduce the available money supply to buy or do things, making the money more expensive to get. On the contrary, when the rate decreases, Fed is increasing the money supply and, by making it cheaper to borrow, it encourages expenditure. The central banks of other countries do the same for the same reason.

Why is this number, what one bank pays to another, so significant? As the interest rate of commercial banks overloads its most solvent customers is mainly based on the federal funds rate. In addition, the basis for mortgage loans and a number of other commercial and consumer loans.

What happens when interest rates increase?

When Fed increases the federal funds rate, it does not directly affect the stock market itself. The only real direct effect is that it becomes more expensive for banks to borrow money from Fed. But, as mentioned earlier, increases in the federal funds rate have a domino effect.

As it costs them more to borrow money, financial institutions increase the fees charged to their customers by borrowing money. People are affected by increased credit card and mortgage interest rates, especially if these loans have a variable interest rate . This has the effect of decreasing the amount of money consumers can spend. After all, people still have to pay the bills, and when these invoices become more expensive, families get less revenue available . This means that people will spend less discretionary money, which will affect the profits and profits of companies.

But companies are also affected in a more direct way because they also borrow money from banks to operate and expand their operations. When banks make loans more expensive, companies can borrow less and not pay higher interest rates on their loans. The lowest expense can delay the growth of a company; it could reduce the expansion plans or creation of new companies, or even induce cuts. There may also be a decrease in profits, which, for a public company, usually means that the price of the shares receives a blow.

Interest rates and shares

So now we see how these subas and drops can shake the stock exchange. If it is considered that a company is reducing its growth or being less profitable, either through higher debt expenses or less revenue, the estimated amount of future money flows will decrease. Under equal conditions, this will reduce the price of the company's shares.

If enough companies have falls in the prices of their shares, the entire market, or the key indices (such as Dow Jones or S&P 500) that many people equal with the market, will decrease. With a lower expectation in the growth and future cash flows of the company, investors will not gain the same growth in the appreciation of the share price, making the holding of actions less desirable. In addition, investment in shares can be considered too risky compared to other investments.

However, some sectors benefit from increased interest rates. A sector that tends to benefit more is the financial industry. Banks, purse belts, mortgage companies and insurance company profits often increase as interest rates rise because they can charge more for loans.

Interest rates and obligations

Interest rates also affect bond prices and income of treasury bonds. There is an inverse relationship between bond prices and interest rates, which means interest rates rise, bond prices fall, and vice versa. The longer the bonus maturity, the more it will fluctuate in relation to interest rates.

When the Federal Reserve increases the rate of federal funds, government bonds such as treasury bonds, are often seen as safer investments and will usually experience a corresponding increase in interest rates. In other words, the “free of risk” income rate increases, which makes these investments more desirable. As it increases the free risk rate, it also increases the total performance needed to invest in actions. Therefore, if the risk premium needed to decrease while the potential return remains equal or low, investors may feel that the actions have become too risky and will put their money elsewhere.

One way governments and companies would raise money is by issuing bonds. As interest rates rise, the cost of the loan becomes more expensive. This means that the demand for low-performance obligations will fall, which will cause your price to fall. As interest rates fall, it is easier to borrow money, which makes many companies issue new obligations to finance new businesses. This will increase the demand for higher performance obligations, which will require increased bond prices.

For income-oriented investors, reducing the federal funds rate means a lower opportunity to earn money with interest. The Treasury's obligations and the recently issued annualities will not pay so much. A decrease in interest rates will drive investors to move money from the bond market to the stock market, which will then begin to increase with the new capital entry.

What happens when interest rates fall?

When the economy slows down, the Federal Reserve reduces the rate of federal funds to stimulate economic activity. A decrease in Fed interest rates has the opposite effect of an increase in rates. Both investors and economists see lower interest rates as growth catalysts, a profit for personal and business loans, which generates higher profits and a solid economy. Consumers will spend more, with lower interest rates, making them feel they can finally allow themselves to buy this new home or send children to a private school. Companies will enjoy the ability to finance operations, acquisitions and expansions at a more economic rate, which will increase their potential for future gains, which will in turn generate higher stock prices.

Large companies with stable cash flows and solid balances benefit from cheaper debt financing.

Impact of interest rates on actions

Nothing really has to happen to consumers or companies so that the value market responds to changes in interest rates. Growing or declining interest rates also affect investors' psychology, and markets are nothing if not psychological. When Fed announces a rise, both companies and consumers will reduce their costs, which will cause a fall in profits and the fall in stock prices, everyone thinks, and the market falls in anticipation. On the other hand, when Fed announces a cut, the assumption is that consumers and businesses will increase expenditure and investment, which will cause an increase in stock prices.

However, if expectations differ significantly from Fed's actions, these generalized and conventional reactions may not be applied. For example, let's say the word on the street is that Fed will reduce interest rates by 50 base points at its next meeting, but Fed announces a fall of only 25 base points. In fact, the news can cause the actions to fall due to the assumptions of a 50-point cut have already been taken into account in the market.

In conclusion

Although the relationship between interest rates and the stock market is quite indirect, the two tend to move in opposite directions: as a general rule, when Fed reduces interest rates, it causes the stock exchange to rise; when the Federal Reserve increases interest rates, it causes the value market to fall. But there is no guarantee how the market will react to any change in the interest rate as Fed decides to do.

Source: Investopedia

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