How Do Interest Rates Affect Stocks
What are interest rates?
An interest rate is the amount a lender charges a borrower. It is the percentage of the borrowed amount. The Federal Open Market Committee (FOMC) sets the interest rate, which banks use to lend and, borrow from one another.
This change in interest rate takes up to 12 months to have an economical effect. However, the ripple effect on the stock market is immediate. As such, it is crucial for investors to understand how changes in interest rates will affect their investment. This will allow you to make better-informed decisions.
While there are different interest rates, the federal funds rate has an immediate effect on the stock market. This is the rate institutions such as, banks, credit unions, and loans charge each other for overnight loaning and lending.
What happens when interest rates rise?
Once the Federal Reserve increases the interest rate, it increases the cost of borrowing for institutions such as banks. The effect is more immediate on short-term loans. As such, the ripple effect affects consumers and businesses alike.
This is because it costs financial institutions more to borrow money. They transfer this increase in rates to their customers. This means interest rates for their mortgages and credit cards increases, reducing the amount of money they can spend.
With less money to spend, paying bills and catering to daily expenses becomes a burden to the consumer. Therefore, revenue for businesses and companies decrease. This ripple effect has a huge impact on the stock market.
What happens when interest rates fall?
A decrease in interest rates happen when the economy slows down. The Federal Reserve then decreases the discount rate to facilitate economic activities. As expected, the effect is opposite to that of increasing interest rates.
Many economic experts view lowering of interest rates as a means to stimulate economic growth. This means the consumer will have more disposable income. As a result, businesses and companies benefit from higher profits while the economy becomes more robust.
Consumers tend to spend more on not only basic needs but also luxuries. For example, they might send their kids to better schools or seek medical services from private hospitals. Likewise, businesses can expand or acquire peer companies significantly increasing their earning potential. As you’d expect, stock prices increase.
Two ways higher interest rates may impact stock prices
An increase in interest rates can either have a direct or indirect impact on stock prices. Let’s look at the two:
Once the interest rates increase, businesses cannot borrow as much. This is because it becomes expensive for companies to borrow short-term loans. As such, the spending of businesses decrease, which leads to, decreased revenue. The stock price of the company will therefore decrease as the revenue decreases.
An increase in interest rates means consumers will have less money to spend. This means there’s less disposable income in the economy. Spending on companies’ products and services will therefore decrease causing stock prices to fall.
Best stocks to analyze when interest rates fall
The following stocks have a better return on investment when the interest rate falls. They include:
Since a fall in discount price increases disposable income in the wider economy, people are more likely to buy more goods. As such, retail stock prices are expected to increase. Some of the stocks you can invest in include:
· Amazon (NASDAQ: AMZN)
Amazon is arguably the leading ecommerce site that sells just about anything. And thanks to their diversification to the grocery industry, consumers are more likely to buy more from them. And as shoppers shift to online shopping, stock prices are expected to increase.
· Walmart (NYSE: WMT)
Close to Amazon is Walmart, which is the leading retail store. While it has many physical stores, its online presence is also robust. This allows it to serve both online and offline shoppers. The company also has lucrative membership deals, attracting hundreds of thousands of customers.
A fall in interest rates can also have a positive impact on utilities stocks. This is because people are spending more fuel, electricity, gas, and more. Here are stocks to consider.
· UGI Corp
UGI deals with the distribution of energy services and products domestically and internationally. It deals with products such as electricity, propane, and natural gas. The company is also pivoting to renewable energy meaning its future earning potential is high.
The company owns and operates several power-generating facilities across the United States. Some of the services it provides include thermal energy production, cogeneration facilities, energy production, and more.You can also buy Pinnacle West Capital utilities stocks when interest rates fall. Through one of its subsidiary, it sells electricity on a retail and wholesale level in the state of Arizona. It is also involved in the real estate industry.
S&P 500 index stocks
These are stocks from 500 top companies. These companies have a proven track record in paying dividends. Some stocks to buy include:
· Apple (AAPL)
Apple is one of the leading tech giants. It produces some of the most sought after electronic gadgets such as the iPhone and iPad. The company is also involved in the internet of things (IoT) and artificial intelligence.
· Microsoft (MSFT)
Microsoft is yet another dominant tech company known for its Windows product. It is also one of the leading cloud infrastructure provider in the market.
Alphabet is the parent company of Google. Google is the leading search engine and produces Android operating system. This is the most popular operating system in the world.
Best stocks to analyze when interest rates rise
While you might think there’s no investment opportunity when the interest rates rise, there are several profitable stocks you can buy. However, you should practice caution when buying the following stocks.
When interest rates rise, banks increase the rates they offer to their customers. As such, they increase their revenue causing an increase in stock prices. Some of the bank stocks to buy include:
· Bank of America (BAC)
Bank of America has weathered some of the worst financial crisis. And it continues to grow stronger. It has increased its loan portfolio keeping it abreast of its competitors. It is also one of the early adopters of online banking and mobile technology. And since it has a high concentration of none-interest paying deposits, its stock prices can increase with increase in interest rates.
· JPMorgan Chase (JPM)
This is arguably the largest bank by market capitalization and one of the most profitable in the industry. It has a footprint in the investment and commercial banking sectors making it one of the most stable banks in the industry. It also invests heavily in fintech, technology, and other disruptive sectors.
· U.S. Bancorp (USB)
Yet a commercial bank, it has many sources of income such as loans. Experts hail the bank for paying dividends in time and its growing profitability. As a commercial bank, its revenue and profitability are more stable and predictable compared to its peers.
High dividend stock
These stocks also do well when interest rates are increasing. It causes a rapid increase in demand forcing prices to rise. Some of the high dividend stocks to invest in include:
· Coca-Cola Company (NYSE:KO)
This multinational beverage company has its footprint around the globe. Millions of beverages are produced every month serving consumers in over 200 countries. It deals with soft drinks, tea, coffee, hydration, and others. In its third quarter it reported a 16%revenue increase reaching $10 billion. It’s earnings per share rose to $0.57 in the same period.
· Caterpillar, Inc. (NYSE: CAT)
Caterpillar is the leading producer of construction equipment and machinery. It also produces natural gas engines, mining equipment, gas turbines, and others. In November, the company announced a partnership with Ballard Power and Microsoft to create green energy from hydrogen.
· Amcor Inc. (NYSE: AMCR)
Amcor produces packaging products used by a wide array of companies. They produce cartons used in the food and health industries, containers, and flexible packaging. Its main focus is to produce renewable, lightweight, and recyclable products.
High liquid stocks
Also known as ETFs, they respond immediately to increase in interest rates. As such, they present a trader with unmatched flexibility to change or exit positions with limited losses. Some of the most popular include:
· Equity ETFs
· Balanced ETFs
· Commodity ETFs
· Volatility ETFs
· Inverse ETFs
· Bond ETFs
You can invest in the Vanguard S & P 500 ETF (VOO) that performs exceptionally during a peak in interest rates.