Interest Rates and the Stock Market

Investors worry about interest rates for good reasons. When the Federal Open Market Committee of the US Federal Reserve raises the target interest rate for federal funds, that action raises rates across the entire economy. While the full effect on the US economy will typically take a year to settle in, the stock market anticipates these effects and reacts immediately. Interest is what companies pay to borrow money and thus the effects of higher rates are greater on highly leveraged enterprises with large debt loads.

High Interest Rates and the Economy

Overall, when interest rates go too high, companies borrow less and spend less. This tends to slow the economy and the higher interest rates go the more pronounced the effect is. When the economy enters an inflationary trend, the Fed will raise rates to “cool off” the economy. And, when the economy slows, the Fed will lower rates to help stimulate spending and the economy. Because of the severity of the Financial Crisis, rates stayed down for years. And, with the Covid-19 crisis and a projected k-shaped recovery, they are likely to stay down again until the economy starts to revive.

Low Interest Rates and the Bull Market

Interest rates went down with the 2008-9 financial crisis and stayed at near to zero until 2015. They rose 2.4% by the end of 2018 and then fell to near zero again with the Covid-19 pandemic crisis. With bonds paying little or no interest, investors put their money in the stock market driving prices up.

What Happens to the Market When Interest Rates Go Up This Time?

The stock market has gone up after the initial shock of the Covid-19 crisis despite high unemployment and a weak economy across many sectors. Companies have gotten used to borrowing at extremely low interest rates. When the economy starts to recover as vaccinations start to overcome the virus, the Fed is likely to raise interest rates a bit at a time. What happens to your investments when interest rates rise?

Companies with no cash reserves and large debts will be in trouble. Companies that have leveraged their stock price growth with expectations of huge gains eventually may find themselves cut off from funding and suffer financial collapses. This could include promising ventures like Tesla whose stock went up more than four-fold this year as it saw its first profitable year in 18 years of existence. However, much of its profit came from the sale of emission credits to other automakers!

Banks will do well as interest rates go up, as they always do unless higher rates drive the economy back down.

Normally, during a recession, stocks are down almost across the board. That is not the case this time and that confuses the issue a bit. As the virus subsides and the economy improves, stocks in the travel and hospitality sectors will start to recover. They are not over-priced and will have some room to run before higher interest rates hurt them. But, the current high-flyers may experience long-awaited corrections.

Worst-hit Stocks When Interest Rates Go Up

The worst-hit will probably be those investments that have been prone to speculation such as those involved in the recent retail investor frenzy and perhaps bitcoin as well. When rates go up the dollar will get stronger on the Forex markets and interest-bearing investments will return to favor.

As always, over the long term, companies with the ability to keep making profits through good times and bad will prosper. Those who purchase such investments when prices are low will do especially well and those who try to get the last bit of profit out of the bull market before higher interest rates force a correction will get hurt.

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The remarks, which had been anxiously awaited all week, sparked an initial reaction to sell stocks that quickly reversed itself. Later in the session, stocks again fell, as investors’ expectations for a rate rise later this year climbed. Treasury yields and the dollar also fluctuated before rising.

Loose U.S. monetary policy has been a driving force in financial markets, keeping the dollar soft and supporting stocks and bonds.

Will higher rates kill the current stock market rally? Despite the apparent fear and trepidation of the market, the Fed is likely to raise rates by another tenth or two tenths of a percent. A little historic perspective on interest rates is in order.

Effective Fed Funds Rate

It has been since before the 2008 market crash that the effective Federal Funds Rate was been anywhere but near zero. However, the Federal Funds Rate has been as high as 19.4% in July of 1981. Courtesy of the Federal Reserve Bank of St. Louis here is a chart showing the Effective Federal Funds Rate going back to 1955.

The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.
The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.

The Federal Open Market Committee meets eight times a year and determines a federal funds target rates which it aims for by buying and selling government bonds. As the graph shows, the historic oddity is the fact that rates have been near zero for eight years! Although high interest rates can hurt the economy we are usually talking about the rates seen in the 1970s. The economy was doing fine in the late 1990s even though the Federal Funds rate was in the 5% range.

Winners and Losers, What and When to Buy

Utility stocks will take a hit on the threat of an interest rate rise as noted by Investor Place.

There’s no arguing that utility stocks have knocked it out of the park this year. Year to date, the Dow Jones Utility Average (DJU) is up better than 18%. Utility stocks are always attractive to income oriented investors because of their dividend yields. But is now the time to buy?

Probably not. In fact, I recently recommend taking profits in utility bellwether Southern Company (SO). But it looks like investors will get an opportunity relatively soon to pick up some high quality names in this dependable, dividend paying sector.

And there likely will be bargains to be had for those looking for secure retirement investments after these dividend stocks over-correct. Dividend stocks are normally considered an alternative to bonds but now days when interest rates are nearly zero dividend stocks are a better bet. Smart investors will wait for a slight correction and then add to their buy and hold portfolio. If rates go too high that could be another issue but look at the Federal Funds Rate graph for a little perspective.

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