Introduction
The interest rate is one of the main tools of monetary policy for central banks. Interest rates refer to the cost of borrowing money that is measured by yield to maturity. There are two types of interest rates, nominal and real interest rates. The nominal interest rate does not account for inflation, while the real interest rate is adjusted for inflation; thus, reflecting the cost of borrowing. Interest rates are scrutinized closely by investors as it affects both the micro and macroeconomy. Two common terms regarding the interest rates are hawkish which means an increase in interest rates and dovish which means a decrease in interest rates. This article will shed light on the impact of interest rates on the capital market, money market, and economic growth.
Effect of changes in Interest Rates on the Money Market
A change in interest rates affects the money market as well which refers to a type of financial market with short-termed high liquidity asset that is interchangeable with money at short notice; hence, the name. Short-term debt instruments include money market funds, short terms CDs, Treasury bills, etc. There is a negative relationship between bond prices and interest rates. In simple words, if you are an investor with a bond that you bought at a par value of USD 100 that gives a coupon of 2 % semiannually, and the central bank decided to increase the interest rate to 5 %, then you'd be more willing to dump your bond at a lower price to benefit from the higher interest rates at the bank and vice versa. Or you'll buy the bond at discount to offset the loss from the higher market rate. And if the market rate (Interest rates) are lower than your bond's yield, you'll get it at a premium which means you'll buy it at a higher price than its par value to offset the
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To precisely measure the sensitivity of the bond's price to changes in the interest rates, we calculate the duration sensitivity. Duration can be calculated by two methods, the Macaulay Duration (MacD) and the Modified Duration (ModD). A bond with a longer time to maturity is more price-sensitive to interest rates which means it has a larger duration than a short-term bond, hence the term duration. In simpler words, if a bond that has only 2 payments left that give 5%, and an interest rate hike happened to reach 10 %, then the investor will be only underpaid for 2 payments, unlike another investor who bought a 30yr bond with 5% interest, who will be underpaid for the next 30 years which will cause a larger decline in the long-term bond’s price than that of the short-termed as seen in the below chart.
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Such that; CF= cash flow amount, f= cash flow number, y= yield to maturity, k= compounding periods per year, k= compounding periods per year, tf= time in years until cash flow is received, and PV=present value of all cash flows
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Effect of changes in Interest Rates on the Money Market
On the other hand, the capital market or the equity market refers to the market where long-termed securities are bought and sold; such as the stock market. A change in interest rate will affect it, as well. According to a study by Nasdaq (November 2021), it was found that growth and tech stocks benefit the most from long-term yields; thus, the Nasdaq index has the highest sensitivity of 2 towards interest rates among the Dow Jones, S&P, and itself.
There is not a clear simple relationship between the stock market and interest rates. Lower interest rates do not necessarily mean a higher stock price and vice versa. the effect differs in the short term versus in the long term, and day traders are affected differently than investors who prefer to buy and hold for a longer-term. But rather the relationship can be deduced from learning from the past, for example, Dow Jones Market Data analyzed the movement of 3 main indices during 5 interest rate hikes, and the results showed that the indices were negative only once during the period June 1999 to Jan 2001, as seen in Table 1 below. While an increase in the Fed rate can show mixed signals, as shown below in table 2.
| Rate Hike Cycle | DJIA | S&P 500 | Nasdaq |
|---|---|---|---|
| Feb. 1994 to July 1995 |
16.30% | 13.80% | 18.10% |
| March 1997 to Sept. 1998 |
17.40% | 32.60% | 40.00% |
| June 1999 to Jan. 2001 |
-1.60% | -5.00% | -13.30% |
| June 2004 to Sept. 2007 |
28.70% | 30.00% | 26.90% |
| Dec. 2008 to July 2019 |
213.70% | 243.10% | 442.00% |
| Average % Change |
54.90% | 62.90% | 102.70% |
| Median % Change |
17.40% | 30.00% | 26.90% |
Table 1| Source: Dow Jones Market Data
The simple general relationship though can be explained as follows; as interest rates increase, businesses incur higher borrowing costs and lower future cash flow accompanied by weakened consumer demand; thus, adversely affecting their stock prices, citrus paribus. As expectations of the market decline, investing in the stock market becomes less desirable and investors tend to turn to the other investment strategies.
However, not all stocks are adversely affected by increasing interest rates. Stocks in the financial industry, for instance, benefit from the rising environment since a higher interest rate means higher earnings for lending. While rising interest rates can hurt growth stocks like Tech startups who depend heavily on financing their operations by borrowing.
| Fed Rate Hike | Next 6 Month | Next 12-Month |
|---|---|---|
| Feb-1994 | -2.60% | 2.50% |
| Jun-1999 | 9% | 8% |
| Jun-2004 | 7.80% | 7.50% |
| Dec-2015 | 1.40% | 11.30% |
| Average | 3.90% | 7.30% |
Table 2| Source: Morningstar (2021)
Impact of changes in Interest Rates on Economic Growth
Changes in interest rates impact the macroeconomy indirectly, including inflation, employment rates, and economic growth. A change in interest rates can occur due to a change in expected inflation. There are two types of real interest rates; Ex-ante real interest rates are adjusted for expected changes in the price level, while the ex-post real interest rates are adjusted for actual changes in the price level. As seen in the below equation, any change in the inflation rate affects the interest rates and vice versa.
i= ir + πe
Such that; i= nominal interest rate, ir= real interest rate, πe= expected inflation rate
The above equation shows that expected inflation rises, nominal interest rates rise, and this positive relationship is called the Fisher Effect. In other words, interest rates rise as inflation rises because moneylenders demand higher interest rates to compensate for the decreased purchasing power of the funds. An example of the positive relationship between the Fed Fund Rate and inflation is that both move in tandem, as seen in the below figure. Therefore, the real interest rate is a good indicator of the tightness of credit market conditions than the nominal interest rate.
At times of inflationary pressure, central banks tend to increase interest rates at moderate rate hikes. This happens to incentive the investors to save their money at the bank rather than spend it, hence reducing the money supply from the economy to eventually stabilize inflation to normal levels, driving interest rates to normal levels as well.
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For example, as global inflation figures rise in late 2021 and early 2022, central banks around the globe decided to increase interest rates at different hikes such as the Bank of England (BOE) increased the interest rates for the third straight hike in rates, an unprecedented pace in almost the past two decades. The US Federal Reserves, as well,
While at times of slow economic growth, central banks decrease interest rates on borrowing to encourage borrowing; thus, encouraging spending. Moreover, since the GDP is a summation of government and consumer spending, investments, and net exports, as one component increases, ceteris paribus, the GDP increases driving the wheel of the economy, achieving higher employment rates, and eventually economic growth.
What happens to interest rates during a stock market crash?
A stock market crash happens when stock prices decline significantly all at once by more than 10 % and might last for years until it fully recovers. There are 6 stock crashes in the history of the stock market, the 1929 Great crash, the 1987 Black Monday crash, the 1999-2000 Dotcom Bubble, the 2008 Financial crisis, the 2010 Flash Crash, and the 2020 Coronavirus market uncertainty. As seen in the chart below the performance of s&p500, Nasdaq, and Dow Jones Indices with Effective Fed Fund rates throughout history. During the 2008 financial crisis, for instance, it is apparent from the graph that the three indices and the Effective Fed Fund Rate moved in tandem, increasing and declining heavily together.
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The first crash followed the Federal Reserves' decision to raise the discount rate in early August to 6%, the DJIA increased by 27 % y-o-y by Sep 3rd. On Black Friday on October 24th, investors traded 3 times the normal volume losing around USD 5 B, and then on Black Monday, the stock market fell further by 13 %. A month later on October 29th, the NYSE collapsed, and by mid-November, the DJIA lost almost half of its value, and it took the DJIA around 25 years to recover from the crash, as seen below.
The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.