How Interest Rates Affect Everything
From stocks to bonds to real estate, every investment is somehow affected by interest rates, albeit to a different extent. To understand that impact, you first have to understand how interest rates work. For most of us, interest is just something we earn on our savings accounts, or (more often) more money we have to pay to credit card companies. For some, it's the mysterious number connected with mortgage payments. And that's where it ends for us; that's the direct impact of interest rates on our lives.
It begins, though, with the Federal Reserve. The Federal Reserve has the power to manipulate the federal funds rate, which is the interest rate that Federal Reserve banks charge other banks like yours to borrow money. That rate sets the tone for all other interest rates, like the ones on your car loan, mortgage, and credit cards. The Federal Reserve uses this rate to control inflation. To keep inflation from spiraling out of control, the Fed raises its rate, which has the effect of limiting the amount of money available for consumer spending. Higher interest rates mean that more money goes to interest payments and less to shopping.
When people and businesses have to pay more in interest, which leaves them less to spend, investors can take a hit. So while a change in the federal funds rate doesn't immediately impact the markets, it does affect them indirectly, through both consumer spending and corporate bottom lines. When corporations have to pay more to borrow money, that's less money for the dividend pool and less money to put toward future growth. Plus, corporations with diminishing profits usually see their share prices drop right alongside the disappearing earnings. So even if nothing else changes, an interest rate increase can push stock prices down.
When the Fed lowers interest rates, the money supply increases. That often signals investors to buy stocks, as lower interest rates make stocks appear more attractive on the risk-return scale. Lower rates also aid economic expansion, which leads to corporate growth, which increases the value of corporate shares.
There's a flipside to this, though. A higher federal funds rate also means higher interest rates paid out on newly issued Treasury securities. These risk-free investments guarantee you steady returns, and when rates go up, you're guaranteed bigger interest payments on these government securities. This also has the effect of higher interest rates on newly issued municipal and corporate bonds.