Impact of Interest Rates on Financial Markets

Readers Question: What are the negative and positive impact of rising in the interest rate on financial market?

Higher Interest Rates and Stock Markets

Higher interest rates are often seen as bad news for the stock market.

Higher interest rates tend to slow down economic growth. Borrowing is more expensive therefore, firms will invest less and consumers will spend less. Because higher rates lead to lower growth, companies will make lower profits and therefore pay less dividends.

Furthermore, higher interest rates make it relatively more attractive to save in banks rather than invest in the stock market.

Of course, there are many variables affecting stock markets other than interest rates, but, ceteris-paribus higher rates tend to be seen as bad in the short term.

Interest Rates and Bonds

Government bonds have a fixed interest rate. E.g they may pay 5%.

If market interest rates increase from 5% to 6%, it means that existing bonds become less attractive. The bond pays 5%, but, you could get 6% elsewhere. Therefore, people will sell the 5% bonds and save elsewhere. This causes the price of bonds to fall.

Simple Example Bond worth £100 interest rate 5%. Bond pays £5 a year.

If interest rates increase to 10%, the bond becomes bad value. The price will fall to £50. Then the £5 annual payment gives an effective interest rate of 10%.

Therefore, bonds have an inverse relationship with interest rates.

Interest Rates and Exchange Rates

Higher interest rates will increased demand for the currency. Higher UK rates make it more attractive to save in the UK, increasing demand for Sterling (hot money flows)

See also:

By on August 1st, 2008

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