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How Do Interest Rates Affect Stock Prices?

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After the 2007 financial crisis, the US Federal Reserve began a program of buying short term bonds from banks. This was a departure from the Fed's traditional policy of setting interest rates. The result was a nice jolt to the stock market that's been shaken in 2015 by the thought that interest rates might rise again—though when rates did rise in December 2015, stocks went up. Who knows what 2016 will bring?.

All of this behavior suggests a more than casual relationship between interest rates and stock prices. Even for value investors this is an interesting dynamic; it affects what you should think about buying as an investment and why.

What is the Federal Funds Rate?

One of the Federal Reserve's primary means of influencing the economy is the Federal Funds Rate. The Fed Funds Rate is the interest rate charged to the world's largest banks when they lend money to each other overnight. (Why loan or borrow money overnight? To meet banking liquidity concerns; however much free cash the institution expects to need on hand for the next day's transactions.)

The Federal Funds Rate is the lowest rate at which a bank can lend or borrow money (with almost no exceptions). This implies that you, as a business or consumer, will pay at least this rate. If a bank wants to make money, it'll lend to you at a rate higher than the Fed Funds Rate.

What does the Fed Funds Rate Mean for the Economy?

When the rate is low, it's easier to borrow money. In a very real sense, lowering this rate is like opening the faucet on a firehose full of money. More money is available to borrow more cheaply. Economics suggests that this is a good way to stimulate a sluggish economy.

When the rate is high, it's more difficult to borrow money. Borrowing is more expensive; the flow of money dries up. Economics suggests that this is a good way to slow down an overheated economy. (Some economists suggest that an overheated economy produces asset bubbles, where houses or dot-com businesses or tulips are more expensive than they're really worth and that eventually there'll be a crash which hurts a lot of people. The rules aren't nearly this clear cut.)

Of course, the global economic reality of the 2010s has demonstrated that modifying monetary policy based solely on manipulating interest rate doesn't work so well when that overnight rate is effectively zero: when hitting the zero lower bound. Hence quantitative easing.

Yet the relationship between interest rates and stocks is still very interesting especially for investors.

Comparing Risk to Rate of Return

As you probably already know about risk, safe investments tend to learn lower returns than risky investments. Sure, a penny stock could earn you 100x returns, but it's more likely that you'll lose everything when a risky company goes out of business.

In a similar fashion, the most boring, most stable, fundamentally risk-free investment in the world—a US Treasury bond—won't pay you much in interest. It will be paid back.

Investors as a whole aren't fools. Every individual investor has a unique appetite for risk. You might be willing to spend time researching individual stocks to get an extra 2% or 3% return annually while your neighbor might put everything in low-cost index funds and not worry about anything. Your risk is a little higher, and you expect a little better return because of it.

That's no guarantee, but the tendency is well established.

T-Bills versus Stocks

The investing criteria of someone like a Warren Buffett is easy to explain: find the safest investment that gets you a better return than a T-bill. In other words, if you're analyzing a stock and it can't earn you more year over year than you'll get in interest from the Treasury bond, buy the bond instead.

When bond interest rates go up, investors buy bonds for their safety. When bond interest rates go down, investors buy stocks for their returns.

What happens when interest rates are effectively zero, as they've been for the past few years? Money continues to flow into stocks. Throw in Quantitative Easing, and you can argue that the Federal Reserve's pumped a lot of money directly into the US stock market.

Of course, it's also easy to argue that the market can get addicted to this easy money. This is one reason the market has dropped when rumors of interest rate hikes circulate; some investors want to sell and take their profits before that steady stream of money dries up.

Can Value Investors Benefit from Interest Rates?

This knowledge is powerful. You may never use it to time your transactions, but you can use it to put economic trends in their proper contexts. It may be more difficult to find bargain stocks when interest rates are low; stock prices will tend to be higher, especially if you consider historical P/E ratios. Yet bargains will exist.

It'll be easier to find undervalued stocks when the market dips due to rising interest rates; but that's the countercyclical strategy of "Buy Low, Sell High".

The best time to start investing was 100 years ago. The second best time is right now. If you're cautious and thoughtful about where you put your hard-earned money, you can pay attention to the relationship between interest rates and stock prices but still invest a little bit every month to meet your long-term financial goals. Predicting the future—predicting what the Federal Reserve will do next month—is a fool's game. Concentrate on the fundamentals. Buy great stocks and good prices and be patient.