The relationship between interest rates and stock markets
One of the tools most used by central banks is the manipulation of interest rates.. When rates are high, borrowing money becomes more expensive for both businesses and consumers, which tends to slow economic growth. On the contrary, low interest rates facilitate access to credit, stimulating investment and consumption.
In the stock marketsinterest rates affect stock valuations in various ways
Cost of financing for companies: Businesses that rely on loans to expand their operations are affected by changes in rates. Higher rates increase financing costs, which can reduce profits and, consequently, share prices.
Relative attraction of other assets: When interest rates rise, safer assets like bonds become more attractive compared to stocks, leading investors to shift their portfolios toward less risky options.
Future valuation of companies: Interest rates also affect the discount rates used to calculate the present value of a company’s future cash flows. A higher rate reduces this value, which can make the stock less attractive.
Expansionary monetary policy and its effects
An expansionary monetary policy, characterized by low interest rates and an increase in the money supply, usually has a positive impact on stock markets. This approach seeks to stimulate economic activity, and investors tend to respond optimistically.
Lower interest rates make the credit is cheaper, encouraging both consumers and companies to spend and invest. This generates economic growth that boosts corporate profits, raising stock prices.
By increasing the money supplycentral banks inject liquidity into the financial system. This provides investors with more resources to purchase assets, including equities, putting upward pressure on markets.
In a low rate environment, returns on safe assets like bonds are limited, pushing investors to look to riskier assets like stocks for higher returns.
A recent example of expansionary monetary policy was the response to the 2008 financial crisis and the COVID-19 pandemic in 2020. Central banks aggressively cut rates and launched asset purchase programs to stabilize markets, resulting in a strong rally in stock prices.
Restrictive monetary policy and its impacts
On the other hand, a restrictive monetary policy, marked by higher interest rates and a reduction in the money supply, seeks to control inflation and prevent overheating of the economy. Howeverthis policy often has adverse effects on stock markets.
Higher rates make borrowing more expensive, leading to a drop in spending and investment. This can translate into lower revenues and profits for companies, negatively impacting stock prices.
Bonds and other fixed income instruments become more attractive to investors in a high rate environment, diverting capital from stock markets.
The investors tend to avoid risky assets such as stocks when the economic environment becomes more uncertain due to monetary restrictions.
For example, in 2022, the Federal Reserve adopted a restrictive stance to combat the highest inflation in decades. This caused a decline in stock markets, with indices such as the S&P 500 recording significant losses due to rising interest rates.
The psychological effects on investors
Monetary policy not only directly affects stock markets through rates and economic incentives, but also influences investor behavior through expectations and perceptions. When central banks announce changes in monetary policymarkets react not only to the change itself, but also to signals about the state of the economy.
For example, an expansionary policy can be interpreted as a sign of economic weaknesswhile a restrictive policy can be seen as a measure to avoid overheating. These interpretations affect market confidence and, therefore, stock prices.
Although monetary policy has a significant impact on stock markets, it is not the only factor at play. Elements such as tax policies, geopolitical events, and company-specific conditions also play an important role. Furthermore, the effects of monetary policy may vary by sector.
For exampletechnology tends to be more sensitive to changes in interest rates due to its dependence on research and development funding. While the financier can benefit from higher rates, since banks can obtain higher profit margins on their loans.
Whether in periods of monetary expansion or restriction, it is imperative that investors pay attention to the movements of central banks and how these could influence their portfolios.