Interest rates can have a significant impact on the economy as a whole and your personal financial life. When tracking changes to interest rates, the stock market is often a major focal point, as rates can affect investors directly and indirectly. The impact of interest rate changes can also be felt more immediately in the markets while it may take time for those impacts to trickle down to the broader economy. Understanding the relationship between interest rates and stock market movements matters for shaping your financial plan.
A financial advisor can offer valuable advice and insight into how a big interest rate change will affect your portfolio.
Interest Rates, Explained
Before digging into the correlation between changes in interest rates and the stock market, it’s helpful to know a little about how rates are set. The Federal Reserve uses interest rate policy to control inflation and pursue full employment. This is accomplished through, among other things, changes to the federal funds rate – that is, the interest rate commercial banks pay one another for overnight loans.
Whether interest rates rise or fall can depend on overall economic conditions. If the economy appears to be slowing down or even heading toward a recession, the Federal Reserve can lower interest rates. That’s important because banks follow suit by reducing interest rates for loans and lines of credit. This encourages borrowing and spending, which can help to stimulate the economy.
In 2020, for example, the Federal Reserve slashed rates to near zero in an effort to control negative economic impacts associated with the coronavirus pandemic. When rates drop, they can remain low for as long as the Fed believes it will take for the economy to begin recovering.
On the other, the Federal Reserve may raise rates if the economy is growing too rapidly. In that scenario, raising the federal funds rate makes it more expensive to borrow, since banks can also raise rates on loans. This strategy is often used to help curb or preempt inflation.
Interest Rates, the Stock Market and Investors
If you have money in the stock market, there are some tangible impacts interest rates can have on your portfolio. How you’re affected can depend on whether you’re invested in stocks or bonds and what’s happening with the economy as a whole. First, consider the relationship between interest rates and bonds. Bonds represent a debt obligation when issued by a corporation, government or another entity. As an investor, you supply money to the bond issuer who pays you interest in return. This interest is paid over a set maturity term.
Interest rates and bond prices move in opposite directions. The longer the maturity term of a bond, the more fluctuation you might see as interest rates change over time. In other words, short-duration bonds are less succeptible to interest rate changes than long-duration bonds.
With stocks and stock funds, interest rates don’t necessarily have as direct an impact. But interest rate changes can affect your stock portfolio, based on which way they’re moving. For example, say the Fed raises rates to counteract rising inflation. This makes business loans more expensive to obtain, which can result in companies shelving plans to expand or refinance debt.
If the company isn’t able to move ahead with its plans, that could shift how its financial stability is perceived by the market. As a result, fewer investors may choose to put their money into the company, which could trigger a decline in the stock’s share price. This could create a buying opportunity for investors but if this is repeated with multiple companies, it could result in a sharp drop in stock pricing across the market.
When stock prices go down on a broad scale, that can set off a bout of panic selling if investors are fearful about the market. In a worst-case scenario, investors could experience a correction, which could result in significant losses.
Interest Rates and Other Investments
Stocks and bonds aren’t the only investments that can be affected by interest rate changes. Increasing or declining rates can also affect things like:
- Cash holdings
- Real estate
If you have some of your portfolio in cash, interest rate shifts could be a boon or a burden. Say you have a sizable amount of cash set aside in a 5-year CD, for instance. If rates rise while your money is locked into the CD, you’re missing out on potential growth unless you have the option to raise your rate during the CD term.
On the other hand, cash held in a high-yield savings account or money market account would be more accessible while benefiting from higher rates. The downside, of course, is that if rates fall then the annual percentage yield on your savings or money market account will also likely go down.
With real estate investments, interest rate impacts can depend on the type of investment and the overall real estate market. For example, say you want to buy a rental property. A low mortgage rate environment could make that easier to do and over time, you could generate more of a return from the rent you collect if you have a lower mortgage payment.
Low rates could also spur more people to spend, which could make it easier to keep your rental unit occupied and have income flowing in. On the other hand, rising rates could make it more difficult to rent out the property if you’ve adjusted rental prices upward to keep pace with a growing economy. Whether that bears out can depend on demand for rental property. The same would be true if you invest in rental units indirectly through a real estate investment trust (REIT).
With commodities, rising interest rates can trigger falling commodity prices and vice versa. Falling commodity prices could be a good thing if you want to buy into those investments but not so much if you’re ready to sell.
How to Manage Interest Rate Risk
If you’re worried about interest rates affecting your investments or overall financial health, diversification is one of the best ways to counter potential impacts. Constructing a portfolio that includes a mix of investments that are more or less sensitive to interest rate fluctuations can help you prepare for eventual rate shifts. For example, you may choose to include both bonds and bond funds on the conservative side of your portfolio. Bonds can allow you to lock in a consistent rate of return over a set maturity date while bond funds can give you the flexibility to buy and sell as market conditions change.
You may also consider a mix of investments that are less correlated to one another. For example, real estate and stocks generally don’t have a strong correlation. What affects the stock market may not always carry over to the real estate market. If you’re concerned about rising rates affecting stock prices, you may use real estate as a hedge against potential inflationary impacts.
Interest rates affect much of your daily financial life, from how much interest you earn on savings to what you pay for a mortgage or car loan. From an investment perspective, interest rates can also play a major part in your portfolio’s performance over time. Understanding the relationship between interest rates and stock market trends can help when deciding how to invest.
Tips for Investing
- If you’re worried about interest rates and inflation specifically, you might consider investing in Treasury Inflation Protected Securities (TIPS). This is a type of Treasury bond that’s indexed to inflation. As inflation rises, the principal of a TIPS increases and vice versa with deflation.
- Consider talking to a financial advisor about what interest rates might mean for your financial plan. SmartAsset’s financial advisor matching tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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