If you trade indices and stocks in the US stock market, you have probably noticed how traders and investors are waiting for signals from the US Federal Reserve regarding interest rates. The day before, the Fed left the rate in the same range and, most likely, will not lower it in March.

Changes in interest rates affect the economy as a whole gradually throughout the year, but the stock market reacts to cuts and increases instantly. Why is this so important for traders? We explain the priority of interest rates for the American economy.

 

Fed funds rate

The interest rate that affects the stock market is the federal funds rate. It is charged by the institutions that issue deposits—banks, savings and loans, and credit unions. In turn, the Fed influences the federal funds rate to control inflation.

By raising the federal funds rate, the Federal Reserve is effectively trying to reduce the supply of money available for purchases. This, in turn, strengthens the national currency. Conversely, when the Fed lowers the federal funds rate, it increases the money supply. Central banks in other countries follow a similar pattern.

 

What is the impact of rising interest rates?

When the Federal Reserve increases the benchmark interest rate, it sets off a chain reaction that affects the cost of borrowing for everyone, including everyday consumers. The Fed’s discount rate, the interest rate it charges commercial banks for short-term loans, serves as a benchmark for other interest rates, including those charged on consumer loans, mortgages, and credit cards.

This means that consumers will face higher interest rates when they borrow money, whether it’s for a new car, a home, or even everyday purchases made on credit cards.

 

The situation during the rate cut

When economic growth falters, the Federal Reserve (Fed) implements a monetary policy tool called lowering the federal funds rate. This move counteracts the effect of raising interest rates, aiming to revitalize economic activity. Lower interest rates, in contrast to higher ones, are seen as a catalyst for growth by investors and economists. This is because lower borrowing costs make it more attractive for businesses and individuals to invest. The resulting economic growth leads to greater profits for businesses and a more sustainable economy.

Interest rates and the stock market

When a company’s growth trajectory falters or its profitability declines, either due to rising debt servicing costs or reduced consumer spending, the anticipated value of its future cash flows diminishes. This, in turn, typically translates into a drop in the company’s share price. If this trend extends across a significant portion of the market, the overall stock market indices, such as the Dow Jones Industrial Average or the S&P 500, may also experience a downturn.

Although, certain sectors may reap rewards from higher interest rates. The financial services industry stands out as one of the prime beneficiaries. Banks, brokerages, mortgage companies, and insurance firms often register increased earnings when interest rates rise, as they can charge higher lending fees.

Interest rates and the bond market

Bond prices and interest rates move in opposite directions: as interest rates climb, bond prices tend to decline, and vice versa. This inverse relationship is particularly pronounced for bonds with longer maturities, as they are more sensitive to changes in prevailing interest rates. When the Federal Reserve raises the federal funds rate, government securities, such as Treasury bills and bonds, become increasingly attractive to investors seeking safety and stability amidst rising interest rates.