The insights in this article will allow you to clearly anticipate the direction of the stock market in the months and years to come by showing how the availability of money affects the stock market.
I’ll walk you through the last 60 years of economic data comparing the Federal Reserve Prime Rate and the S&P Composite Index, so you can assess the current state of the economy and therefore the direction of the stock market.
How do interest rates affect the stock market?
Interest rates affect the stock market in two ways. A long-term prime rate below 5% encourages economic expansion, which is seen in the growth of the stock market. A high interest rate stifles investment and causes the economy and the stock market to contract. Equally important is the direction and speed of interest rate changes. Rapid increases in interest rates cause volatility and a crash in the stock market; rapid declines can promote a rapid recovery.
First, we start with a brief understanding of monetary policy.
Video: Explanation of Interest Rates vs. the Stock Market
Monetary policy controls interest rates
“Monetary policy is the process by which the government, central bank or monetary authority of a country controls (i) the supply of money, (ii) the availability of money and (iii) the cost of money or the rate of interest, in order to achieve a set of objectives oriented to the growth and stability of the economy ”.
Monetary theory provides information on how to design optimal monetary policy.
Monetary policy is known as an expansionary policy or a contractionary policy, where an expansionary policy increases the total money supply in the economy and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation.
“Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxes.”
Okay, that’s the painful part out of the way. Let’s see what that really means:
- Money supply, money availability and money cost (Prime rate) they are essentially controlled by governments or government-appointed central banks.
- These factors are used to try to ensure economic stability.
- By using a lower cost of money and a greater availability of money, a government can stimulate economic growth. This means stimulating business and reducing unemployment, which equates to stock market growth and real estate growth, but can increase inflation.
- Increase the cost of money through Interest rates or restricting the money supply can be used to combat inflationary pressures in the economy, but this generally has the effect of making it more expensive to borrow; therefore, companies obtain a lower return on invested capital and lower profits. This drives down stock prices, real estate prices, and increases unemployment.
60 Years of Interest Rates vs. the S&P Composite Index
Figure 1 shows exactly how monetary policy affects the stock market by overlaying the US Prime Rate about him S & P500 Returns from 1954 to October 2009.
What is the prime rate? The prime rate is the cost for businesses or consumers to borrow money. The published rate is usually the rate for favored clients with a lower risk profile; if your risk profile is higher, you may have to pay a higher interest rate.
The prime rate is important because if a company has 80% of its bank loan capital and has a profit margin of 5%. Imagine, what would happen to the company’s profits if interest rates went from 5% to 15%? The company’s profit margin could be cut by 2% or almost in half if everything stayed the same.
Therefore, a company may seek to maintain the profit margin by reducing its costs and trying to pay off part of the debt. Most of the time, cost reduction often comes in the form of reduction of people; therefore, unemployment increases. Businesses could also increase the cost of the product or service they provide; however, this could lead to less sales and less profit, so they would have to ditch staff anyway.
S & P500 Index vs. Federal Reserve Prime Rate Example
We can clearly see from this graph which is the biggest influence on the direction of the stock market.
- The mid to late 1970s saw a stock market stagnation. Then the cost of money was lowered in the form of interest rates. A prime rate above 10% has contributed greatly to a stagnant stock market at least, or at worst, a period of severe decline.
- Vigorous reductions in prime interest rates in the early 1980s sparked a huge bull market.
- The continuation of low interest rates and the rise of cheap credit fueled an economic boom that lasted until 2000, except for the 1987 crash, which actually looks like just a bump compared to the overall advance.
- Rates were lowered again as the economy flourished.
- Rates were slightly increased to try to reduce overheating, but remained below 10%. This did not have a significant effect on the stock market or the economy. The prime rate increased slowly during the five-year period before the 2000 Dotcom crash. The prime rate was used to try to curb overheating in the developed world. It worked.
- Unrealistic expectations in the economy and in the stock market fueled even the internet craze and the boom in tech stocks had to explode. This is the idea of the bursting of the bubble.
- When the bubble burst, central banks cut interest rates to halt the dangerous slide. Three years later, the market finally bottomed out and began to resume the usual uptrend.
- Speeds were slowly increased again to try to avoid overheating. This time it didn’t work.
Something very different happened in 2008 to cause one of the most violent crashes in the world stock market since the Depression. This time it was not the cost of money but the money supply, the other factor mentioned in our definition of Monetary Policy. The availability of money was severely restricted due to a lack of trust among financial institutions. Neither institution knew who had so much exposure to the subprime market that it was collapsing at the time. Therefore, banks stopped lending to each other, drastically reducing business and consumer lending. This had a much faster and more devastating effect on the economy than the slow rise in interest rates could have. This was similar to someone simply turning off the lights.
What is a good interest rate for stocks?
60 years of research shows that interest rates below 10% are good for stock market profitability, below 5% produces strong stock market performance and close to 0% produces a recovery from the economic crisis and stock market booms. The availability of cheap money through low interest rates creates speculation in property, stocks and commodities, which must be controlled with good financial supervision and regulation.
Will stocks fall when interest rates rise?
My analysis shows that slow increases in interest rates over several years, which remain below 5%, will not cause stocks to fall drastically. Any large increase in interest rates will immediately affect property prices and cause companies’ balance sheets to contract, which will affect stocks.
The most common causes of stock market crashes they are not interest rates, but poor management of institutional risk, easy access to credit and capital bubbles.
Live Chart: Federal Funds Prime Rate.
Here’s a live graph of the Federal Reserve Prime Rate. Remember, rapidly rising interest rates, especially above 5%, will cause the stock market to crash.
 “Monetary policy.” Board of the Federal Reserve. January 3, 2006. http://www.federalreserve.gov/policy.htm.
 BM Friedman “Monetary policy,” International encyclopedia of social and behavioral sciences, 2001, pp. 9976-9984