The stock market and long-term investors watch interest rates with great, well, interest.
The relationship between stocks and interest rates is complex and, depending on the industry, a potential boon or disaster.
From a high-level view, interest rates determine how easy or hard money is to borrow, which is another way of speeding up or slowing down the economy.
The Open Market Committee of the Federal Reserve, often referred to as The Fed, determines interest rates, to a certain extent.
The Fed uses interest rates to speed up or slow down the economy (more below). This is not a precise tool and can lead to applying too much pressure on the accelerator (lowering interest rates) or too little pressure (raising interest rates).
There is a constant state of disagreement among economists and within The Fed over whether interest rates are too high, too low or just right given the economic conditions.
Unfortunately, there is usually no way to know for certain until some time has passed which group was correct. The economy can suffer lots of damage in the interim.
Some industries depend heavily on borrowed money to fund daily operations and low interest rates helps them be more profitable, while higher interest rates may slow growth since more resources are consumed paying off debt.
The stock market (and, more importantly, the companies represented there) uses capital (money) for fuel.
Capital is not free for companies to use.
Companies pay for capital one of two ways:
- They can give up part ownership and sell shares of stock
- They can borrow it
When a company sells shares of stock in the public markets, that piece of ownership can then be traded among investors.
It is important to note that once a company sells a share of stock on the open market it no longer receives any benefit (or loss) if the share of stock rises or falls in price other than the increase or decrease in value of the stock the company retains..
Companies, especially young, growing enterprises, often issue (sell) stock as a way to raise money to fund growth.
The benefit of selling shares of stock is that the company does not have to pay the money back.
If a company doesn't want to give up ownership by selling stock, it must borrow the money it needs to fund growth.
There are many sources of money for companies to use:
- Bank loans
- Equipment financing
- And others
Borrowed money must be repaid, so the company must be certain the funds will improve business enough to generate cash for loan payments.
When interest rates are low, companies often use low-cost borrowed money to fund growth.
Companies use bonds extensively for large construction projects, acquisitions and other big capital needs. Bonds usually give the company a way to borrow over a longer term than many other lending arrangements.
Depending on how credit worthy the company is, it may issue bonds at very attractive rates that may be repaid over time even if interest rates rise.
However, in a market where interest rates are high, it may not make business sense to borrow money.
When regulators keep interest rates low, they are trying to encourage businesses to expand and create new jobs.
If the economy expands too quickly (inflation) thanks to low loan rates, regulators may take steps to drive up interest rates and slow down borrowing and expansion.
It's not unlike how you might plan a vacation. If gasoline is inexpensive, you may decide a long vacation trip is a good idea.
However, if gasoline is expensive, you may decide to stay closer to home.
If you think of interest rates as fuel for the economy, low interest rates encourage borrowing, while high interest rates discourage expansion.