How Do Higher Interest Rates Impact Stocks?
By Scott Aune, Investment Manager
It's commonly assumed that higher interest rates mean lower stock prices.
From an investor's perspective, many stocks pay dividends but the price of stocks can be much more volatile than the price of bonds. Bonds pay interest, but their prices are generally more stable than stocks. As bond interest rates increase, stock dividends may become less attractive since investors will prefer the higher income and greater price stability of bonds. Following this through to its conclusion, as interest rates rise and eclipse the rate of stock dividends, investors may increase their positions in bonds, causing the price of bonds to rise; and reduce their positions in stocks, causing the prices of stocks to fall.
From a business perspective, higher interest rates represent higher borrowing costs to companies, making it more expensive to do business, which may result in lower profit margins and therefore a lower stock price.
Now that the Fed has begun raising interest rates, many investors are concerned with the impact rates have on stocks. Although higher rates are not necessarily good for stock prices, the good news is that rising interest rates aren't necessarily bad for stocks either. The conundrum lies in the fact that, in some situations — an expanding economy, for example — interest rates and stock prices can rise together. We are seeing this phenomenon now as the economy strengthens — and that's a good thing.
The underlying message is that as the economy gains strength, increased consumer demand for goods and services may lead to more profitable companies and higher stock prices. In turn, companies will want to expand, purchase additional equipment, etc., increasing the demand for credit which results in higher interest rates. So, for a time, stock prices and interest rates can rise together.