How do interest rates affect the stock market?

The general relationship between the stock market and interest rates

While interest rates are more commonly associated with bonds than stocks, the relationship is quite evident during periods when the Federal Open Market Committee (FOMC) adjusts its benchmark interest rate, the federal funds rate. Generally speaking, Fed policymakers raise rates to cool inflation when the economy is growing and decrease them to spur demand when the economy is slowing.

If the Fed is hiking interest rates, it’s usually when the economy is strong, which is a good indication for the stock market, notes Falko Hörnicke, senior vice president and senior portfolio manager at U.S. Bank. If those increases are gradual, investors can adjust their valuation models for the potential effect on future earnings and cash flow. 

What matters more is how quickly interest rates are changing. “Speed is always a very, very important determinator of how markets react,” Hörnicke says.

To appreciate that relationship, look at last year. Federal Reserve policymakers undertook an aggressive strategy to hike interest rates to combat red-hot inflation, raising the target for the federal funds rate from a range of 0% to 0.25% at the start of 2022 to a range of 4.25% to 4.5% by year’s end. The S&P 500 Index fell 19.4% during 2022 for its worst year since 2008.

The market’s performance reflects how investors had to reassess their expectations for stock prices as the Fed was raising interest rates “quickly and violently,” adds Keith Buchanan, senior portfolio manager at Globalt Investments. Higher interest rates make it more expensive to take out loans for big-ticket items like homes and cars, which should slow down the pace of economic activity and cool inflation, he adds.

How certain sectors are affected by higher interest rates

Within the broader stock market, some sectors are more affected by changes in interest rates than others. That relationship depends largely on their business models, including their customers and profit margins.

• Financial stocks. Financial stocks benefit from a rising rate environment because these companies can make money from a time lag on the change in rates, Hörnicke says. Banks can push through higher interest rates that they charge customers to borrow money, but may wait a little longer to raise the rates on savings and checking accounts, he adds. Capturing this spread on interest rates can be a “very, very strong place for banks to earn money,” he says. 

• Consumer discretionary stocks. Presuming the Fed is raising interest rates amid a healthy backdrop in the economy, then consumer discretionary stocks can also benefit from rising rates, Hörnicke says. This sector, which retailers and restaurants, will benefit if the economy is growing and consumers have more disposable income to spend. 

Real estate, consumer staples stocks, and utilities stocks. Conversely, these sectors may not benefit from higher interest rates, though for very different reasons. Demand for real estate may be hurt by higher borrowing costs. Consumer staples companies that sell essential goods typically have thin margins, so it can be difficult to increase prices amid higher inflation. Finally, utilities stocks may attract more investors when interest rates are low rather than high because they typically pay high dividends. 

What interest rate activity makes the stock market go up

When the Fed is raising interest rates, it will increase borrowing costs and potentially slow the pace of economic activity — both of which could weigh on corporate earnings and stock prices. “Higher interest rates in the short-term might have a negative effect on stock prices, but in general it’s not a bad thing,” Hörnicke says.

Presuming that interest rate hikes are gradual and underpinned by a strong and growing economy, the stock market could go up in a period of rising interest rates. This was true during the period between December 2015 and October 2019 when the FOMC enacted nine rate hikes that took the federal funds rate from a range of 0% to 0.25% to as high as a range of 2.25% to 2.5%. In that same timeframe, the S&P 500 Index rose nearly 50%.

What interest rate activity makes the stock market go down

Speed once again matters when the Fed cuts interest rates. Gradual rate decreases may be accompanied by short-term rises in stock prices as cheaper borrowing costs could spur demand. 

As with rate increases, however, when the Fed quickly and aggressively slashes interest rates — as it did during the onset of the COVID-19 pandemic in March 2020 — the stock market could fall amid fears of a broader economic slowdown. “Capital markets don’t like uncertainty,” Hörnicke notes.

How to invest when interest rates are changing

Recent years have given investors a crash course on how the market reacts to interest rate changes, as the Fed has both aggressively slashed and raised interest rates since 2020. Rather than focusing specifically on what the Fed is doing, investors should ensure they have a solid financial plan and a well-diversified portfolio, Hörnicke says. 

When interest rates are in flux, you may want to focus more on the above sectors that benefit from rate changes — and one way to do so is by buying exchange-traded funds (ETFs) that track stocks in those sectors, Hörnicke advises. A patient mindset is also important, particularly right now given the uncertainty about the outlook for interest rates. “The pendulum was way too low on the low side and now it’s swinging way too high to the high side.”

The recent volatility in the stock market reflects how even seasoned investors are trying to keep up with the changing rate environment — and what the Fed plans to do after hitting its terminal rate, or the rate at which there won’t be any more increases. 

“No one knows how this will all come together,” Buchanan says. “A lot of investors are really grappling with how to invest in this environment.”

Instead, focus on your long-term investing goals and prepare for some “unexpected turns” in the market in the next 18 months, just as has happened in the last 18 months, Buchanan advises. “Investing is going to come with some bumps and bruises,” he says. “Going with the punches and learning as we go would be the most advantageous way to navigate this.”

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as Financial and Home Services Editor for the Hearst E-Commerce team. Email her at lauren.williamson@hearst.com.