The last few months of 2024 were marked by the Federal Reserve (Fed) cutting the federal funds target rate by 1% between September and December. This is a rate used by banks with each other for overnight lending. As Kavan Choksi mentions, Fed rate cuts are typically encouraging to equity investors.
Kavan Choksi underlines how changing interest rates affect the stock market
Interest rates can impact the stock market in many ways. In most cases, when the rates go up, equities are challenged as investors may opt to invest in bonds that pay more attractive yields. High interest rates may put pressure on the valuations of stocks, as corporations might have to generate more attractive earnings in order to capture the interest of the investors. The bottom line of corporations is another way the interest rate environment affects stocks. If a debt-issuing company faces high borrowing expenses owing to rising rates, it may lead to reduced company profits, thereby lowering stock prices. Such factors are among the major reasons why equity investors pay close attention to the interest rate environment.
It typically takes about twelve months for a change in interest rate to have a widespread economic impact. However, the response of the stock market to this change is generally more immediate. Markets often attempt to price in future expectations of rate hikes by the Federal Open Market Committee (FOMC).
In addition to the federal funds rate, the Federal Reserve also sets a discount rate. This is the interest rate charged by the Fed to banks that directly borrow from it. The federal fund rate is generally higher than the target federal funds rate, and encourages banks to borrow from other banks at the lower federal funds rate. While the federal funds rate is a key driver, there also are several other factors that influence how the stock market reacts to interest rate changes. These factors include geopolitical events, economic growth projections and inflation expectations.
In the opinion of Kavan Choksi, the estimated amount of future cash flows typically goes down in case a company is seen to cut back on its growth or is less profitable due to less revenue or higher debt expenses. This may lower the price of the stocks of the company. The key indexes that many people equate with the market like the S&P 500 will go down if enough companies experience stock price declines. Investors shall not enjoy much of growth from stock price appreciation with a lowered expectation in the growth as well as future cash flows of a company, thereby making stock ownership seem less desirable. There, however, are certain sectors that do benefit from an increase in interest rates. The financial industry is one such sector. The earnings of insurance companies, mortgage companies, brokerages and banks typically go up when interest rates are higher, as these organizations can charge more for lending.
Investors also need to be aware of the concept of real interest rates that account for inflation. This rate can be negative if inflation is rising faster, thereby supporting higher asset valuations even if nominal rates are rising.