How interest rates affect stock prices

Central banks set a policy interest rate that influences borrowing costs throughout the economy, and financial markets watch their decisions closely. Changes in rates ripple through to share prices in several ways, but the relationship is not mechanical, and it often surprises people. This article explains the main channels, shows the valuation effect with numbers, explains why expectations matter so much, and what it means for investors.

The main channels

• Borrowing costs. Higher rates increase the interest that companies pay on debt, and the cost of loans for consumers, such as mortgages. That can squeeze profit and slow spending and investment. Falling rates have the opposite effect.
• Valuation. The value of a share depends on the profits it is expected to produce in the future. Those future profits are discounted, which means they are worth less today the further away they are, and the discount rate is linked to interest rates. When rates rise, future profits are worth less in today's money.
• Competition from safer assets. When bonds and savings accounts pay more, shares have to look more attractive to compete for investors' money. When rates are very low, shares can look more appealing by comparison.
• The exchange rate, since higher rates can attract foreign capital and strengthen a currency, which affects exporters and importers differently.

The valuation effect in numbers

Take 100 of profit that a company expects to receive in 10 years.

• Discounted at 4% a year, it is worth about 67.6 today (100 divided by 1.04 to the power of 10).
• Discounted at 6%, it is worth about 55.8 today.

The same future profit is worth about 17% less because the discount rate is two points higher. This effect is larger for companies whose profits lie further in the future, such as fast-growing firms that reinvest most of their earnings, than for companies whose profits are mostly near-term. This is one reason why high-growth shares have often been more sensitive to changes in interest rates. In 2022, for example, when central banks raised rates rapidly, many high-growth shares fell sharply.

Different sectors react differently

• Banks and insurers can benefit from higher rates if they earn more on loans and investments than they pay out, but they can suffer if borrowers struggle or if their bond holdings lose value.
• Utilities and real estate often carry a lot of debt and pay high dividends, so they can be sensitive to rates in both directions.
• Growth and technology companies are often more sensitive through the valuation channel.
• Cyclical companies are affected through the effect of higher rates on demand.
• Companies with lots of cash may benefit from higher interest income.

Expectations matter

Markets look ahead. Prices adjust when investors expect a change in rates, not only when it happens. A rate increase that was fully expected may have little effect on the day, while a surprise can cause a large move. What the central bank signals about the future path of rates, in its statements and projections, often matters as much as the decision itself. This is why markets can rise on a day when rates are increased, if the central bank signals that it is near the end of its tightening.

The reasons for the change matter too

Rates reflect the economy. Central banks often raise rates when the economy is strong or inflation is high, and cut them when growth is weak. So:

• Rising rates in a growing economy can coincide with rising profits, which may offset the negative valuation effect.
• Falling rates in a downturn can come with falling profits, so share prices may not rise.

The same move in rates can have different effects depending on the reason behind it.

What it means for investors

• Do not trade on rates alone. The link is real but unreliable in the short term, and even professionals find it hard to predict.
• Know your exposure. Understand how sensitive your holdings are to rates, particularly if your portfolio is concentrated in one style, such as high-growth shares or high-dividend shares.
• Diversify. A mix of assets that respond differently to rates can reduce the effect of any single move.
• Match your debts and investments to your outlook and horizon. If you hold variable-rate debt, rate rises affect you directly as a borrower.
• Think long term. Interest rates move in cycles, and a long-term investor will experience both rising and falling rate periods.

Common mistakes

• Assuming that rate rises always cause share prices to fall, or that cuts always cause them to rise.
• Ignoring expectations and focusing only on the announced decision.
• Forgetting that the economy and profits are also moving.
• Making large portfolio changes in response to a single central bank meeting.
• Overlooking the difference between sectors.

A short checklist

• I understand the main channels from rates to share prices.
• I know which of my holdings are most rate-sensitive.
• I pay attention to expectations and signals, not only decisions.
• I do not base my strategy on predicting rates.

Use interest rates as one input into your view of the market, not as a prediction tool. The effects are real, but they interact with many other forces.