The Effect of Interest Rates on Stock Prices

When the economy is doing really well and interest rates are low, companies borrow money and expand their operations. New jobs are created and investors have extra money to save and invest. With more buyers entering the investing stock prices move up. If the economy increases too rapidly or becomes too large, inflation also increases thus making goods more expensive. To prevent inflation from rising, the Fed will raise interest rates to try and curb the economy from increasing too rapidly. Stock prices will tend to decrease as the interest rates go up. There are several factors relating to the movement of the interest rate that are to blame.

Stocks must compete with bonds for the investors' dollars. As interest rates increase bonds become more attractive to investors thus reducing the number of buyers in the marketplace. As the ratio of buyers to sellers decreases so does the stock prices. Also, as interest rates increase, older bonds with low interest rates must decrease in value to stay competitive with the new bonds. This also makes some bonds more attractive thus pulling away more buyers and causing stock prices to drop.

As interest rates increase companies must pay more to borrow money and this reduces profit. As the cost of business increases and

firms become less profitable, fewer earnings can be passed to investors making stocks less appealing. With less buyers stock prices will tend downward.

As interest rates increase not only does it cost companies more to borrow but consumers will borrow less as well due to the increased cost of borrowing. With less money available to consumers, ie investors, fewer will be willing to pump money into consumer products. With a decrease in consumer spending, firms will have a decrease in earnings. Decrease in earnings means less profit equals less investors willing to buy. Stock prices forced downward again.

There is a bright side. If the reason your stock price went downward was due to rising interest rates now is the time to buy!!! The economy is cyclical and interest rates will go down and economy will go up again...and so will the stock prices.

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