How do interest rates affect stock market investments?

Interest rates are a key concept in economics and finance, and they affect even our personal lives – from credit card debt to mortgage or a car loan, interest rates are a key part of financial education.

What are interest rates? How does a change in the interest rate affect our stock market investments? Read on to discover how interest rates affect your investments.

interest rates uk

What are interest rates? High or low interest rates

The interest rate is nothing more than the price of borrowing money.

Central banks, such as the Bank of England (BoE), set interest rates. Essentially, they can impact the entire economy by changing the rates at which other banks can borrow money, which in turn affects the interest rates set by the banks for individuals and businesses.

High interest rates impact the financing of companies as it makes loans more expensive. Also, with high interest rates, investments are less profitable for companies and this affects their bottom line.

In the event that interest rates are very low, there is a risk that companies borrow too much money and grow their debt excessively. If the interest rates rise at a later time, they may go insolvent if they cannot cover their interest expenses. Some companies may rely more on debt than others, such as capital-intensive companies in technology or manufacturing.

Who sets the interest rates?

The interest rates are set by central banks:

  • Bank of England
  • FED in the United States.
  • ECB (European Central Bank) for the Eurozone (i.e., for the countries that adopted euro as their currency)
  • Central banks in other countries.

What factors influence the decreases and increases in interest rates?

There are several factors that impact the interest rates, but the most important ones are inflation and exchange rates.

Inflation

Central banks can adjust interest rates to control inflation. For example, in periods of economic booms, where investment flows, the prices of goods and services can start rising uncontrollably (inflation).

In this case, the central bank can increase interest rates, which in turn makes savings more appealing (as you get higher returns) and makes borrowing and investment more expensive. Hence, instead of spending, businesses and households choose to deposit their money to get high interest on their funds, and lower spending helps to control the rising level of prices in the economy.

One example of such investments is bonds. Bonds pay a fixed income (interest rate/coupon), so when interest rate increases, it's profitable to invest in bonds.

Exchange rate

The Bank of England (BoE) can influence the exchange rate of the British Pound through its interest rate policy. In short, when the BoE adjusts interest rates, it impacts the attractiveness of holding GBP-denominated assets.

  1. Higher interest rates: If the BoE raises interest rates, it usually leads to an increase in the return on savings and investments in GBP. This can attract foreign capital, as investors seek higher returns. As demand for GBP increases to purchase these assets, the exchange rate of the GBP tends to strengthen against other currencies.
  2. Lower interest rates: Conversely, if the BoE lowers interest rates, the return on GBP-denominated assets decreases. This can make these assets less attractive to investors, leading to a potential outflow of capital and a decrease in demand for GBP. As a result, the exchange rate of the GBP might weaken against other currencies.

Employment and economic growth

Employment and economic growth can also impact interest rates:

  • Low unemployment: When unemployment is low, it typically indicates a strong economy. More people working means more income, which often leads to increased spending and potentially higher inflation. To control inflation, central banks might increase interest rates. Higher interest rates can cool down spending and borrowing, helping to manage inflation.
  • High unemployment: Conversely, high unemployment usually signals a weaker economy. Central banks might lower interest rates to stimulate economic activity. Lower interest rates reduce the cost of borrowing, encouraging businesses to invest and consumers to spend, which can help in reducing unemployment.
  • Strong economic growth: When the economy is growing rapidly, there is a risk of overheating, which can lead to high inflation. In such scenarios, central banks may raise interest rates to slow down the pace of growth to a sustainable level and control inflation.
  • Slow economic growth or recession: In periods of slow growth or recession, central banks often lower interest rates. This action is aimed at stimulating economic activity by making borrowing cheaper for businesses and consumers, thereby encouraging investment and spending.

How does the interest rate affect the stock markets?

Interest rate is essentially the price for borrowing money, but time also is a key element. For instance, when interest rates are high, investors will favour short-term assets – for instance, short-term bonds. When interest rates are low, investors prefer risk-on assets whose returns are in the longer term, such as stocks.

What happens if interest rates go down? Which sectors benefit?

If interest rates go down, the first one affected is the bond market. Bonds offer coupons (interest rates), hence they will not be as profitable with lower interest payments.

Meanwhile, low interest rates mean borrowing is cheaper, so companies invest in new projects and expand their operations to generate more income. This can lead to a bull run in the stock market, driving stock prices up. With cheap borrowing and lots of growth, investors buy stocks and drive their prices even higher.

In a low-interest scenario, the sectors that benefit the most are those that are capital-intensive, such as technology, renewable energy, and manufacturing, as borrowing is cheaper and they can expand easily.

However, in a high-growth economy, inflation will start going higher (the general level of prices). At this point, the central bank may decide to intervene and increase the interest rate to control the inflation.

Some examples of growth companies that benefit from low interest rates are:

CompanyTickerSector
TeslaTSLATechnology
RivianRIVNTechnology
NvidiaNVDATechnology
Meta PlatformsMETATechnology

What happens if interest rates rise? Which sectors benefit?

If interest rates rise, new bonds will also offer high coupon payments, so investors flock to fixed-income assets instead of the stock market. As interest rates are higher, capital-intensive companies will start to struggle with their interest payments on the existing debt.

In this case, some companies may benefit from the general uncertainty. Defensive industries, such as food, transportation, or healthcare are good choices because they will retain interest even in this scenario. This is because their products and services are necessary for humans, so their revenues tend to remain stable no matter the phase of the market cycle.

Some examples of defensive stocks would be:

CompaniesTickerSector
NestléNESN.SWFood
Coca-colaKOFood
PfizerPFEPharmaceutical
Johnson & JohnsonJNJDiscretionary consumption

Summary

In conclusion, interest rates are mainly affected by:

  • Inflation
  • The strength of the currency
  • The health of the global economy

In short, when interest rates increase, investors favour bonds. When interest rates decrease, investors favour stocks.

Read more about the stock market and investments

FAQs

How does the Bank of England decide on interest rates?

The Bank of England's Monetary Policy Committee (MPC) meets regularly to set the Bank Rate. They base their decision on various economic indicators, aiming to keep inflation near the government's target level.

How do interest rates affect the UK economy?

Interest rates influence consumer spending, business investment, inflation, and exchange rates, all of which are crucial components of the UK economy.

What impact do interest rates have on the British Pound (GBP)?

Higher interest rates can strengthen the GBP as they attract foreign investment. Lower rates can have the opposite effect.

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