Interest rates are often called the price of money. They determine how expensive capital is to access for companies, but also for individuals and even governments. ~ Jonathan Schramm
The Federal Reserve controls what is called the federal funds rate, which is the rate banks pay to borrow from other banks. Other interest rates throughout the system are based on that rate.
When an economy is in recession or unemployment is high, the Fed lowers rates. This is meant to encourage investment and spending, pushing more money into the economy.
Inflation is a sign there is too much money in the financial system and economy. One way to reduce the monetary supply is to give people and businesses an incentive to take on less debt. A good way to do that is to raise rates. And this is just what the Federal Reserve is doing.
Interest rates affect stocks in two main ways: the impact companies’ bottom line and impact investor’s behavior.
Many companies “roll over” their debt. This means they never really pay their debt, just pay the interest and renew their old bonds with new ones. In this case, rising rates mean the new bonds will cost the company a lot more in interest expenses going forward.
Some companies are also highly reliant on cheap debt to keep afloat or grow. Others rely on customers spending on credit cards. These companies’ profits might suffer in an environment of rising rates.
This is why a rising rate environment favors skilled stock pickers. A solid balance sheet, low debt, cheap valuation, or high profitability will be very valuable in an environment of rising rates.
Higher interest rates are a disincentive for investors to plow borrowed money into asset markets. That’s one of the main reasons why stocks, cryptocurrencies, and other assets crashed in 2022.
Rising rates for borrowed money tends to cause capital flow out of markets, depressing the values of even quality companies. That hurts investors who bought at the top, especially if they bought at the top with borrowed money. For others it creates a valuable entry point.
Overall, rising interests rates and tightening the money supply are a useful tool to help bring inflation under control. But the recent interest rate increase might not have been enough and there’s probably more to come. If inflation stays high, we would need rates continue to rise to curb inflation.
The positive aspects for US investors:
- Rising rates support a stronger dollar.
- A strong dollar makes US imports cheaper.
- A strong dollar support consumers’ spending by decreasing import costs.
- Rising rates might help to keep inflation under control.
The negative aspects for US investors:
- Currency devaluation can hurt overseas investments measured in USD.
Overindebted companies and consumers might not be able to manage higher rates. - Rising rates decrease demand for big-ticket items like homes and vehicles.
- Rising rates increase the risk of a recession.
- Rising rates make US exporters less competitive.
- Rising rates restrict the use of borrowed money by investors, decreasing demand for assets across the board.vehicles.
- Rising rates increase the risk of a recession.
- Rising rates make US exporters less competitive.
- Rising rates restrict the use of borrowed money by investors, decreasing demand for assets across the board.
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