Value Line University

Interest Rates

Fluctuations in interest rates usually affect the stock market. That's partly because the level of interest rates affects the appeal of stocks versus bonds. When interest rates are high, bonds are more attractive relative to stocks: when interest rates are low, bonds become less attractive relative to stocks. But it's also because a change in the level of interest rates can affect corporate profits.

Higher interest rates often mean lower profits. If interest rates rise, companies have to pay more to borrow the money they need to grow. Eventually that translates into higher prices for their goods and services and, often, slower sales, especially if customers are buying on credit and have to pay higher interest rates themselves to borrow. Potential customers may decide they can't afford to buy.

The eventual decline in corporate sales and earnings is something investors anticipate as soon as interest rates go up. The result is that stock prices may go down even before the effects of the increased interest rates are actually felt on the company's bottom line.

The reverse happens when interest rates fall. Company borrowing costs are lower, so their profits on the same level of sales will be higher. And customers who buy on credit are more comfortable buying if they are paying lower rates, so they buy more. That increases sales and ultimately means higher corporate profits. Higher profits result in higher stock prices.

In this situation as well, investors are typically ready to pay higher prices for stocks as soon as interest rates drop in anticipation of the cycle of increased profits.