When the interest rate increases, borrowing money from banks becomes more expensive for individuals and businesses alike. With higher costs, firms report lower earnings, and in turn, lower stock prices. For investors, this is a crucial thing to be on the lookout for when determining a good time to buy or sell. How do interest rates work, and why do they affect share prices?
The Federal Funds RateIf you're wondering what to look for when wondering what's impacting stock prices, look to the federal funds rate. This is an interest rate used for charging overnight loans, which affects banks, loans, and credit unions. The Federal Reserve will adjust this rate to get a handle on inflation. When this gets increased, acquiring money costs more interest, therefore limiting the amount in supply. When the rate is decreased, it does the opposite. When the rate is lower, it promotes spending, and more money is cycled through the economy.
Most people are affected by the prime interest rate, which is influenced by the federal funds rate, and is what banks charge their customers. Additionally, it's used to set APRs, rates for mortgages, and various other loan rates.
Financial institutions need to have the money their borrowers are looking for. So, when the Fed increases rates, these institutions increase their rates as well. This can make it harder for people to pay credit card debt, buy a car or a house, or acquire a loan for another reason. Because some expenses are necessary, these increased rates can be difficult to avoid. As a result, consumers spend far less on other things, like non-essential goods and services. The inevitable tightening of budgets generally leads to businesses yielding smaller profits, and in turn, lowering stock prices.
But, when the federal funds rate is decreased, this provides greater opportunities for borrowing money and increased spending, often leading to economic growth and higher stock prices as a result.
If the federal funds rate is high, as it has been this year, and companies across the board see a decline in stock prices, key indexes, like the Dow Jones, may likely drop in correlation. If share prices are low, the next step for investors may not be clear. Many might feel defeated if they lost money and try to overcompensate to make up for it. Although, this is never the best decision, as it can lead to additional losses. This is why it's best to consider fluctuations and changes in interest rates when choosing your investments. It's important to evaluate your risk and consider your financial situation before making any trades. Although, rate hikes can impact various sectors differently. Some stocks in certain industries are more stable than others, so keep this in mind when thinking about your investments.
Even though interest rates can determine market movements, the Fed doesn't actually have to do anything to cause share prices to change. Even if they simply make an announcement one way or the other, the markets will react. Just knowing that an increase or decrease is coming can move share prices up or down. So, if an announcement is made where the Fed expects interest rates to go up by a certain amount, but only goes up just a little, the market would have likely already reacted to the initial news of the increase. Additionally, know that this is not the only thing that matters when it comes to stock price changes. While it's a contributing factor, it's only one of many.
The bottom line is that investors should always keep an eye on the markets and updates from the Federal Reserve. Keeping an eye out for market news and reports from companies you invest in can help you make better trading decisions.
Disclaimer: Securities trading is offered to self-directed customers by Webull Financial LLC, member SIPC, FINRA. All investments involve risk, including the possible loss of principal. You should consider your investment objectives carefully before investing. This is not a recommendation, investment advice, or a solicitation for the purchase or sale of a security. Additional info: webull.com/policy |
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