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MoneyVidya.com Investor Essentials: Why interest rates affect stock markets Tuesday, 07 April 2009    Page 1

Overview In the days when interest rate changes were announced without warning, you could see some of the most dramatic share prices movements of the year immediately following them as the markets responded to the new interest rate environment. Now that changes in the official interest rate are generally anticipated / leaked in advance of an announcement, movements on the stock market are generally much more measured. Although the pace of the adjustment may have changed the magnitude of the changes has not. So why do interest rates have such a big impact on the stock market? There are several reasons why the inverse relationship between interest rates and stock prices holds; lower rates typically mean higher stock prices and vice versa. The three main reasons are associated with the impact rates have on; macroeconomic conditions, the attractiveness of equity as an asset class and the cost of transacting. Macroeconomic conditions Low interest rates are good for business, it makes it cheaper to borrow funds, invest in new projects and expand supply. Low interest rates also increases consumption as debt finance becomes more palatable for the consumer. It can also increaese people’s disposable income as existing interest payments, partciularly on floating rate loans are reduced. Because of the positive impact that low interest rates have on business investment and private consumption a reduction in interest rates typically increases revenue expectations for most businesses. Assuming a relatively benign inflationary environment, this increases expected earnings, pushing up company valuations and stock prices. Naturally an increase in rates has the opposite effect by making investment and consumption less attractive, therefore reducing corporate earnings expectations and pushing stock prices downwards. Tuesday, 07 April 2009    Page 2

Asset attractiveness An increase in interest rates also makes equity relatively less attractive as an asset class because the risk-free return available elsewhere increase. As interest rates go up, bank deposit rates rise and new issues of government securities are made at a higher premium rate. This means that investors can get a higher rate of return without taking any risks by putting money into government debt or bank deposits An increase in the risk-free rate of return means that the risk premium associated with investing in the stock market, the reward for taking the extra risk of buying equity, declines. As the relative reward for investing in stocks falls, investors move money out of the stock market and into bank deposits and government bonds, pushing down the price of shares. Similarly as interest rates fall, the risk premium for stocks goes up and new money moves into the market from lower risk (fixed income) investments, pushing up prices. Cost of transacting Much of the volume in the markets these days, whether retail or institutional, is made ‘on margin’. This means that initially the investor only has to put up a fraction of the funds needed to buy shares and the remaining funds are loaned by the broker on a short term basis. An increase in interest rates increases the cost of margin trading. As the cost of trading increases, marginal profit opportunities begin to look less attractive and as a result demand volume is reduced and the price of shares falls. Conversely a reduction in benchmark interest rates makes margin trading more affordable, increases the number of buyers in the market and pushes up stock prices. Tuesday, 07 April 2009    Page 3