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Central banks all around the world change interest rates according to a multitude of factors affecting the economy. Primarily, interest rate changes are determined by the going rate of inflation. When inflation is high, central banks raise rates to slow borrowing and cool down the economy, while they lower interest rates to boost consumption and spending to fuel economic growth.
The stock market is an ever-changing place that reacts to changes in economic sentiment and activity. This is how interest rates can affect stocks. Interest rate changes mean that it becomes more expensive for companies and investors to borrow money, as they have to pay higher amounts in interest. This can make investors and companies more conservative in their choices, thus, lowering the rate of economic growth and the returns of the stock market.
When consumers spend less and deposit more savings in their bank accounts, corporate profits can be lower and individuals are less likely to risk their capital on the stock market. Contrary to this, lower interest rates can boost consumption and economic growth.
"It all comes down to interest rates. As an investor, all you're doing is putting up a lump-sump payment for a future cash flow." - Ray Dalio
When interest rates are increased by central banks, the rates at which commercial banks lend their money also increase. This means that institutions and individuals have to pay more in interest if they are to take out loans from a bank, which prompts them to be more frugal and conservative with their borrowing and spending habits.
When an individual spends conservatively, the revenues of major corporations also suffer, as there is less consumption and less demand for their products and services.
Additionally, the same corporations borrow less money to fuel their growth, which reflects on investor sentiment and can cause the market to go into a downturn, or stagnate, for an extended period of time.
If such interventions from central banks are done too swiftly and not in increments, the sudden drop off in demand and consumption can spiral into a recession and affect the entire national economy. As low consumption and low borrowing also mean less investment, it leads to less growth.
"At the end of the day, it's not a normal condition to have interest rates at zero." - Lloyd Blankfein
Knowing this, central banks around the world are very cautious about not causing a recession when increasing interest rates to combat high inflation, as this will result in thousands of lost jobs and can bring the economy under a lot of stress. Less corporate profits and less disposable income for consumers can also reduce the expected tax revenue for the government. A national budget that is already heavily burdened with debt could struggle to repay its growing liabilities, which will result in the downgrading of its credit rating - creating a spiral of uncertainty that is difficult to manage and contain.
On the other hand, what happens when central banks lower their interest rates to unprecedented levels as they did after the 2008 financial crisis?
When interest rates are very low, consumers and businesses take on more debt to get the necessary cash for their needs. For individuals, this may be to purchase property, make investments, spend on leisure, etc. When businesses are placed in an environment with low-interest rates, their first course of action is to fund operational growth through cheap credit.
This is especially favorable for startups, as they have a lot of room for growth and cheap credit allows them to do so without overburdening themselves with finance costs.
However, if low-interest rates persist for longer than necessary to boost growth, consumers and businesses could build up a market sentiment of unreasonably high growth expectations.
This can be dangerous for the economy, as corporations begin to speculate and pile on more debt to invest in highly risky endeavors. This can increase inflation rates and prompt central banks to start hiking interest rates.
As mentioned in the prior section, sudden increases in interest rates can cause the economy to enter a recession, and consumers and businesses might not be best equipped to adjust to sudden changes.
An interesting example of how interest rate changes affect the stock market is the 2021-2023 stock performance of the ARK Innovation ETF, which invests in high-growth and innovative technology stocks. The ETF ballooned in value thanks to the near-zero interest rates in 2021, which meant that investors invested heavily in stocks, as bonds and other securities offered incredibly low returns. This prompted investors to take more risks on the stock market - pushing valuations higher.
The ARK Innovation ETF, which is invested in high-growth stocks from a variety of innovative, futuristic industries, gained massive amounts of value as the stock market boomed during a period of low-interest rates and government stimulus. However, once interest rates started to increase, the fund quickly lost most of the ground it had gained over the previous two years.
The example illustrates how periods of low-interest rates can boost growth to unsustainable levels and how dramatically a market correction can affect the stock prices of some of the most popular ETFs.
A high-interest environment makes it difficult for ARKK components to raise capital and boost growth, as consumption has also tapered off. Another issue that has contributed to the steep fall of the ETF is the number of its unprofitable portfolio companies.
High-interest rates can be brutal for unprofitable companies, as interest payments on huge loan piles eat away at the bottom line of these companies - deepening their losses and prompting management to cut costs elsewhere.
Interest rates can greatly affect investor psychology and the overall market outlook. Since there is plenty of historic data available, investors are now fully aware of the potential of high or low-interest rates and can trigger bullish or bearish runs on the market without an actual trigger.
When interest rates are low, investors expect companies to take on cheap debt to fund a wide number of activities and continue growing. This expectation can translate into bullish runs on the market. However, these runs can also severely overvalued stocks and drive them further away from their book values.
The 2021 bull market saw hundreds of stocks reach all-time high valuations, while some of them were consistently unprofitable and did not even have any near-term plans to turn a profit.
Low-interest rates can make investors overly optimistic about the future growth prospects of stocks, which can stimulate risky, and sometimes reckless, behavior.
On the contrary, high-interest rates make investors more frugal and conservative and many investors prefer the steady yields from bonds and bond funds, as opposed to risky growth stocks and other speculative ventures.
Stock prices tend to fall when interest rates start to rise, as many companies struggle to find growth capital and try to be conservative with investments, which causes limited growth in stock values.
Low-interest rates stimulate the stock market, as companies take on cheap debt to finance growth and new ventures. However, if low-interest rates persist, it is easy for companies to become overleveraged and lose a lot of value once a market correction takes place.
High-interest rates can prompt investors to take some of their money out of the stock market and put it in bonds, as they offer stable, attractive returns that do not require much oversight and active management. Doing so can cause stock prices to fall, as there is simply not a lot of capital exchanging hands.