Select Page
  • Investing Hot Sheet
    The S&P broke below the key 4400 following the Fed’s “higher for longer” narrative. Can this week’s PCE report put the rally back on track?
  • An Overview of Three Major U.S. Stock Indices
    One way to evaluate the overall strength of the stock market is monitoring an index. The DOW, NASDAQ, & S&P 500 are good examples.
  • What does “Priced In” Mean to Investors?
    “Priced in” is a term financial pundits use to describe news that is already factored into a stock’s price.

How Do Higher Interest Rates Impact the Economy and Stocks?

Aug 2, 2023 | Research

If you’ve seen any financial news in the last 18 months, you’ve likely heard that the Federal Reserve [Fed] has been raising interest rates. In fact, the latest hike in July brought the Fed funds rate to the highest level since 2001, and the Fed predicts that interest rates will rise further by the end of the year. With interest rates on the rise, now is a great time to answer the question – what do higher interest rates mean for the economy and stock markets?

What is the Fed funds rate and why does it matter?

The Fed funds rate is the rate at which banks borrow and lend to each other overnight. It is set by the Federal Open Market Committee [FOMC] and is the Federal Reserve’s primary tool for influencing the economy. While not directly a goal of the Fed, the Fed funds rate can also affect investment markets.

For most people, the rate that banks pay and receive for short-term funds isn’t a concern. Instead, the impact arises indirectly, because the Fed funds rate is a baseline for other interest rates like mortgages, business loans, personal loans, and bonds.

How does a higher Fed funds rate impact the economy?

Since the Fed funds rate impacts other interest rates, a higher Fed funds rate increases borrowing costs for both individuals and businesses. These higher costs work to “slow” the economy in a few ways.

Reducing Consumer Demand

Higher borrowing costs make individuals less likely to buy large ticket items which typically require financing. This reduces demand for these items. Additionally, individuals with variable rate loans like credit cards, home equity lines of credit, personal lines of credit, and adjustable-rate mortgages can see their debt payments rise. This leaves less room in their budget for other spending and therefore reduces demand for items they would have otherwise purchased.

However, demand does not typically decline equally across the economy during a rate hike cycle. Consumers tend to continue spending on necessities like food, shelter, and transportation, while reconsidering large purchases like cars, appliances, and homes. Additionally, consumers tend to cut their “fun” expenses like vacations and luxury items as rates rise.

Slowing Business Expansion

Similar to the way higher borrowing costs reduce large purchases for consumers, businesses are less likely to borrow money when interest rates rise. This means companies purchase fewer buildings, less equipment, and invest less in technology. Without these expansionary purchases, business growth can also slow.

Lowering Profits for Some Businesses

Like consumers, companies with variable rate loans can see their current debt costs rise, which squeezes profit margins. Additionally, lower demand can reduce sales in interest-rate sensitive sectors and therefore diminish profits.

Indirectly Increasing Unemployment

Higher borrowing costs and lower demand can lead businesses to cut expenses in other areas – like their labor force. For this reason, a rise in unemployment often follows a cooldown in the economy.

Each of these factors is interconnected and a slowdown in one area tends to lead to a similar outcome in another. For example, if consumer demand falls, businesses produce fewer products and therefore need less labor. When labor declines, fewer people have income to put back into the economy, and consumer demand falls – restarting the cycle.

How does the Fed funds rate impact stock markets?

Macroeconomic factors can have an indirect impact on stock prices. Higher borrowing costs, lower consumer demand, and a slower economy can all work to reduce stock prices. There are also more immediate effects of higher interest rates. One of these is the risk-free rate, which is used to determine a value for a set amount of income received at a certain time in the future. This is especially important for the valuation of ‘growth’ stocks, so changes in interest rates can have an outsized impact on them.

The risk-free rate is typically synonymous with the 3-month Treasury bill yield. Since bond yields tend to move with the Fed funds rate, tighter monetary policy typically increases this rate, therefore decreasing growth stock valuations. Additionally, bonds become a more attractive investment option when their yields rise. For this reason, stocks that pay steady dividends can lose some investors to higher-paying bonds.

While higher interest rates can lead to reduced stock prices for some companies, the effects are not equal across all industries. Some companies are less impacted, or even inversely impacted, by macroeconomic factors. For example, discount retailers can thrive in a slower economy and bank lending income can increase with higher interest rates. Additionally, value stocks are not typically valued using a discount model and are therefore not impacted by changes in the risk-free rate. Further, many stocks are not interchangeable with bonds, so they don’t typically lose investors to higher yielding bonds. These factors mean that there are opportunities to profit from stocks, even when interest rates are on the rise.

How can you respond to higher interest rates?

Your response to higher interest rates depends on your goals and situation. If your goal is long-term growth, you may not want to change much due to higher interest rates. On the other hand, if your goal is short-term gains, you may want to adjust your portfolio to capture the upside.

Finding opportunities in a rising rate environment can be challenging. If you have the time and inclination to complete the analysis yourself, you could leverage fundamental analysis and technical analysis to locate stocks that you expect to perform well with interest rates on the rise. Additionally, an experienced wealth manager can help you position your assets to make the most of the current landscape.

Discuss Your Portfolio with The Experienced Advisors at DreamWork Financial Group

With interest rates rising, it is important to have an experienced wealth manager who can help you understand how these rates impact you and your portfolio. At DreamWork Financial Group, we can help you determine your goals, then guide you toward investing decisions that help you reach them.

Our innovative wealth management program, Investing Gameplan™, includes a custom portfolio of ETFs and individual stocks. You also receive a dedicated portfolio manager who can adjust your portfolio to match the current economic environment. Best of all, Investing Gameplan™ is open to investors of any net worth. That is just one way we offer fiduciary financial advice that is innovative, transparent, and inclusive.

To learn more and get started today, contact us.