Interest Rate Impact on Equity Market: Central Bank Policies and Beyond

Central banks play a significant role in influencing the equity market through interest rate policies.

Lower interest rates can boost economic growth by making borrowing cheaper, which in turn can increase consumer spending and business investment. This is evident in the article's discussion of the 2008 global financial crisis, where central banks cut interest rates to stimulate economic recovery.

Rising interest rates, on the other hand, can slow down economic growth by increasing borrowing costs, which can lead to reduced consumer spending and business investment. As the article highlights, the 2018 interest rate hike by the US Federal Reserve led to a decline in the US stock market.

The impact of interest rate changes on the equity market can be significant, with even small changes in interest rates leading to substantial fluctuations in stock prices.

Higher interest rates can lower the price of a company's stock if it's seen as cutting back on growth or becoming less profitable.

The estimated amount of future cash flows will drop if a company is less profitable due to higher debt expenses or less revenue.

This can make stock ownership less desirable, especially if investors expect lower growth and future cash flows.

The financial industry tends to benefit from interest rate hikes, as banks, brokerages, mortgage companies, and insurance companies can charge more for lending.

Banks' earnings often increase as interest rates move higher, which can boost the financial sector.

Real interest rates, which account for inflation, could be negative if inflation is rising faster, potentially supporting higher asset valuations.

Growth stocks that derive more of their value from expected future earnings are often more sensitive to interest rate changes.

Investors should be aware of the relationship between interest rates and stock valuations to make informed decisions.

Central banks play a crucial role in managing economic conditions through interest rates. By adjusting rates, central banks send signals about their outlook on economic growth and inflation.

Central banks, such as the Federal Reserve in the U.S., use interest rates as a tool to manage economic conditions. Adjustments to rates send signals about the central bank's outlook on economic growth and inflation. For example, lowering rates is often seen as a stimulus measure, encouraging spending and investment, which can boost investor confidence and stock prices.

The federal funds rate, set by the Federal Reserve, is the interest rate that impacts the stock market. It's the interest rate that banks, savings and loans, and credit unions charge each other for overnight loans. The discount rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans to depository institutions, usually overnight.

Central banks influence the federal funds rate to control inflation. It's effectively attempting to shrink the supply of money available for making purchases by increasing the federal funds rate. This in turn makes money more expensive to obtain. Conversely, the Federal Reserve increases the money supply when it decreases the federal funds rate, encouraging spending by making it cheaper to borrow.

Here's a breakdown of the potential impact of interest rate cuts on the stock market:

The cost of capital is a crucial factor in a company's growth prospects. It refers to the expenses companies incur to finance their operations through debt or equity.

Low interest rates make borrowing more affordable, allowing companies to invest in growth opportunities. This can lead to higher revenues and profits, and sometimes even rising stock prices.

Higher interest rates increase borrowing costs, making companies hesitant to take on debt for expansion. This can slow growth and lead to lower earnings, negatively impacting stock prices.

During periods of rising rates, companies may postpone capital expenditures, affecting their long-term growth prospects and stock valuations.

Central banks, like the Federal Reserve, use interest rates to manage economic conditions. They adjust rates to signal their outlook on economic growth and inflation.

Lowering interest rates is often seen as a stimulus measure, encouraging spending and investment, which can boost investor confidence and stock prices. Conversely, raising rates may signal concerns about inflation or an overheating economy, leading to increased market volatility and declines in stock prices.

The Federal Reserve influences the federal funds rate to control inflation. This interest rate affects the stock market, making money more expensive to obtain when it's high.

Here's a breakdown of how interest rate changes can impact the stock market:

In expansionary periods, interest rate cuts can have a positive effect on the stock market. Historically, both equity and Treasury markets have performed well after the Fed cuts interest rates during an economic expansion.

Lower interest rates can have a positive effect on the stock market. This is because lower rates lead to lower borrowing costs for companies, which can boost their profits.

A decrease in interest rates by the Federal Reserve has the opposite effect of a rate hike, and investors and economists view lower rates as catalysts for growth. Lower rates can lead to greater profits and a robust economy.

The anticipation of a lower federal funds rate by the Federal Reserve can move other interest rates lower, which helps boost general economic growth and corporate profits. This is because many companies borrow for the short term with debt that resets each quarter.

The decline in interest rates can occur even when the Fed keeps the federal funds rate at a high level. For example, the 2-year short-term Treasury yield fell to 3.61% in 2024, down from its peak near 5.24% in October 2023.

Lower interest rates can also make consumers feel more confident about spending, which can lead to increased economic activity. This is because lower rates make borrowing cheaper, making it easier for people to buy big-ticket items like houses or send their kids to private school.

The anticipation of lower interest rates can also boost stock prices. Futures traders began pricing in overwhelming odds of a September rate cut in 2024, which helped the stock market bounce back from an early August selloff.

The bond market is heavily impacted by changes in interest rates. As interest rates rise, bond prices fall, and vice versa. This is due to the inverse relationship between bond prices and interest rates.

A 5.9% cut in interest rates in 1929 led to a 15% return on government bonds, while a 3.1% cut in 1931 resulted in a 30% return. On the other hand, a 1.0% cut in 1933 led to a 0% return on government bonds.

As interest rates fall, it becomes easier for entities to borrow money, resulting in lower-yielding debt issuances. Market demand for existing, higher-coupon bonds increases, causing their prices to rise and yields to fall.

The average performance of government bonds during interest rate cutting cycles is 5%. However, this can vary depending on whether there is a recession or not. During recessionary cuts, government bonds have averaged a 7% return, while during non-recessionary cuts, they have averaged a 2% return.

The table below shows the average performance of government bonds during interest rate cutting cycles:

It's worth noting that the risk-free rate of return increases as the federal funds rate goes up, making bonds more desirable. However, this can also lead to a decrease in the demand for stocks, as investors may feel that stocks have become too risky.

Economic Trends play a significant role in shaping the stock market. During economic expansions, interest rates typically rise as central banks aim to control inflation.

This can lead to stock market volatility as investors react to changing rates. Rising rates can also deter consumer spending, reducing demand for products and services and affecting corporate profits.

Rising inflation can pressure company costs, further impacting profit margins and stock prices.

Lower interest rates can encourage spending on big-ticket items like homes and cars, which drives demand for goods and services and boosts corporate revenues and profitability.

This increase in consumer spending often correlates with economic growth, positively impacting stock market performance as investor optimism about future earnings rises.

Higher consumer spending can lead to a surge in demand for products and services, resulting in higher corporate profits and stock prices.

However, rising interest rates can have the opposite effect, increasing borrowing costs for consumers and deterring spending, which can adversely affect corporate profits and stock prices.

For instance, if rising rates lead to a slowdown in consumer spending, companies may lower revenue forecasts, prompting investors to reassess their stock valuations.

During economic expansions, central banks often raise rates to control inflation, which can lead to stock market volatility as investors react to changing rates.

Interest rates significantly influence consumer behavior, with lower rates encouraging spending on big-ticket items and higher rates deterring spending. This can boost corporate revenues and profitability, or reduce demand for products and services.

During economic expansions, interest rates typically rise as central banks aim to control inflation, leading to stock market volatility as investors react to changing rates. In downturns, central banks often lower rates to stimulate growth, potentially leading to bullish trends in the stock market as investor confidence returns.

Recessionary rate cuts can result in significant and prolonged equity declines, with an average maximum drawdown of -19.44%. In contrast, expansionary rate cuts typically result in shorter and shallower market downturns, with an average maximum drawdown of -4.91%.

The chart below shows the performance of cyclical sectors (e.g., Energy, Industrials, Technology) against defensive sectors (e.g., Utilities, Consumer Staples) across different cutting cycles.

In slow easing cycles, cyclical sectors tend to outperform defensive sectors, with smaller drawdowns due to their lower sensitivity to economic cycles. In fast easing cycles, defensive stocks experience less volatility, often driven by their inverse correlation with Treasury yields.

Sector sensitivity is a crucial factor to consider when evaluating the impact of interest rates on the equity market. Different sectors exhibit varying degrees of sensitivity to interest rate changes.

Utilities, real estate, and consumer discretionary sectors are typically more affected by fluctuations in rates. This is because they often rely on debt, making them vulnerable to rising interest rates that increase borrowing costs.

Financial institutions, like banks, may benefit from higher rates as they earn larger spreads between loan and deposit interest. This can enhance profitability and boost stock prices.

In slow cutting cycles, cyclical sectors tend to outperform defensive sectors. This is because cyclical sectors, such as Energy, Industrials, and Financials, have lower sensitivity to economic cycles and tend to experience smaller drawdowns.

The chart compares the performance of cyclical sectors against defensive sectors across different cutting cycles. It's worth noting that defensive stocks experience less volatility, often driven by their inverse correlation with Treasury yields.

Here's a breakdown of the sectors that tend to perform well in slow cutting cycles:

In fast easing cycles, defensive stocks tend to maintain more stable performance, indicating their role as safe havens when economic uncertainty looms.

Low interest rates can drive up stock prices as investors seek higher returns in equities. Conversely, rising interest rates can make fixed-income investments more appealing, leading to selling pressure in the stock market.

Investors should be prepared for potential stock price fluctuations in the near term, but equities remain well-positioned due to strong economic fundamentals and solid corporate earnings growth. This is especially true for long-term investors who can ride out market volatility.

The Standard & Poor’s 500 Index, which represents the U.S. stock market, can help investors keep pace with inflation through equity returns. It's essential to discuss your portfolio's current mix of investments with your wealth professional and consider making changes in response to an evolving capital market environment.

Bond prices and interest rates have an inverse relationship, meaning bond prices fall as interest rates rise and vice versa. The longer the maturity of the bond, the more it fluctuates following changes in the interest rate.

As interest rates rise, the risk-free rate of return increases, making bonds more desirable. This can lead investors to shift their money from stocks to bonds, causing selling pressure in the stock market.