In the following article, we will discuss the correlation between the raising of interest rates and the stock market.
The Federal Open Market Committee (FOMC) consists of five presidents of Federal Reserve Banks and seven members from the Board of Governors of the Federal Reserve System. When this committee agrees on and sets the target for the federal funds rate—the rate at which banks lend and borrow overnight—the entire United States economy, including the stock market, is influenced.
What Happens When the Fed Raises Rates?
The federal funds rate is the interest rate at which banks lend and borrow money from one another overnight. Even if this is not the rate customers pay, the Fed’s actions still impact consumers’ daily borrowing and saving rates.
The Fed aims to raise the federal fund’s target rate to boost the cost of credit throughout the economy. Everyone needs to pay more in interest payments due to higher interest rates, which make loans more expensive for individuals and companies.
Those who are unable or unwilling to make the higher payments can put off projects that require financing. People are also encouraged to save money in order to receive larger interest payments. This reduces the amount of currency in circulation, reducing inflation and slowing economic activity.
Impacts on the Stock Market
When inflation becomes too high, or asset bubbles become uncontrollable, the Fed raises interest rates to cool things down.
The stock market can be affected by higher market interest rates. When the Fed raises interest rates, the cost of doing business increases for public (and private) enterprises. Public companies’ revenues and profitability may decline due to increasing costs and less business, which could affect their growth rate and stock values.
Higher interest rates may induce investors to sell assets and profit. Investors may sell stocks and move into defensive investments when the FOMC announces a rate hike. Boring savings instruments like high-yield savings accounts or certificates of deposit (CDs) may become more appealing to some conservative investors if interest rates rise significantly.
The Dynamic Relationship between Interest Rate and Stock performance
Always keep in mind that rate hikes do not affect every industry equally. The high interest rate can benefit certain industries such as financial stocks. For the financial industry in the lending business, higher rates means higher margins.
On the other hand, the high rates tend to harm the growth stocks like startups. In volatile markets, investors prefer stable companies such as commodities and established tech companies.
That is why most people should invest in diversified portfolios to have exposure to the short term winners even though they hold some losers. This strategy helps investors to be a long-term winner.
Please visit our academy to read more about Islamic Finance-related topics.
Feel free to sign up for our free stock screening services at musaffa.com.