In this guide
Interest rates directly impact most people’s finances through their savings returns, mortgages or the costs of other forms of borrowing.
For investors in shares, there is another area that rates can play into how well-off they feel. The headline number set by the Bank of England can significantly move the stock market in either direction.
Multiple factors are involved in this, both at individual company level and across the economy as a whole.
This article covers:
- Relative attractiveness of cash and bonds
- Cost of borrowing
- Economic slowdown
- Expectations
- The effect on the pound and dollar
Read more: How do interest rates affect inflation?
Relative attractiveness of cash and bonds
The relationship stocks have with bonds and cash savings rates is a fundamental driver of how prices move. The attractiveness of any asset as an investment is relative. The different options open to investors as to where to put their money will have varying potential rewards and risk levels. The aim is to target the investments with the best balance of risk and reward, relative to your goals and individual circumstances.
A significant rise in interest rates changes these calculations in a big way. With interest rates at 0.25%, government bonds and cash savings are a relatively unattractive option. While there is low risk, there is also virtually no return.
With rates spiking up to 5%, though, a good return can be had from cash and government bonds with the same low risk. They therefore become more attractive than stocks to some investors. Many will sell out of stocks to buy government bonds or hold cash as a result, pushing down prices.
The inverse is also true. With the average annual return of the S&P 500 topping 8%, leaving money in cash savings earning less than 1% is far less attractive, even taking into account the higher risk of holding stocks.
Read more: How to invest in the S&P 500
Cost of borrowing
Higher interest rates make all borrowing more expensive. Individuals and businesses will find their budgets squeezed by higher payments on mortgages and any other loans which are not at a fixed rate.
As well as the potential for existing loans to become more expensive, any new loans will be available only at higher rates, reflecting the underlying base rate rise.
With the budgets of households and businesses being squeezed, all this means there is less money available to come into the stock market. If an individual has to choose between paying their mortgage and buying stocks, the mortgage wins. Multiply this across many millions of people and the impact is significant.
Read more: Should you invest in European stocks?
Economic slowdown
Higher interest rates slow down economic activity and growth. This is not an accident, it is the aim. The Bank of England raises the rates to reduce inflation. They are required to keep inflation to 2% and the base rate is their main tool to achieve this.
Due to the higher costs of borrowing that result, all manner of economic activity is restricted at individual, company and whole economy levels. This reduces demand for goods and services over time and inflation drops.
The downside is that most companies find it harder to make profits when the economy slows. Their current earnings and projected future earnings suffer, and this is reflected in share prices.
When the economy slows, firms are also less likely to hire people and invest in new technology, which makes it harder for them to grow profits. This negative feedback loop can persist until rates are cut.
Read more: The Magnificent Seven stocks: Still a great opportunity or overpriced and set to fall?
Expectations
Due to the fact that higher rates slow economic activity down, raise the cost of borrowing and make government bonds and cash more attractive options as discussed, people expect stocks to fall in price. It becomes a self-fulfilling prophecy to a degree, with investors collectively selling because they believe share prices will fall, and this selling actually causes the fall they feared.
The reverse is very much true too. This is why when investors collectively believe interest rates will fall stocks begin to rise, even if rates have not yet been cut. This has been demonstrated clearly in the first quarter of 2024.
It is important to keep in mind that expectations of what a central bank will do with interest rates in the near future tend to drive stock prices more than the actual changes to the rate. This is because rate changes become priced in before they actually take place.
Read more: When will interest rates go down?
The effect on the pound and dollar
Higher interest rates in a country increase the value of the nation’s currency relative to others. This makes the goods and services being sold by that country’s businesses more expensive to foreign buyers and therefore reduces the amount some companies earn from exports.
If prices are not raised by the exporter, then they receive less money on everything they sell once it is converted back into their own currency. This additional downward pressure on their profits can be reflected in their share prices, adding to the slump.
The other side of this particular coin is that for countries where the currency has fallen relative to the dollar or other major currencies, the money they make in dollars on exports will be worth more once converted back to pounds. This has been a significant factor in the rise in the FTSE 100 seen in early 2024.
Read more: Is now a good time to buy UK shares?
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