One of the things that seems to weigh heavily on investor’s minds is interest rates. Generally, low interest rates are good for stocks and high interest rates are bad for stocks. But why?
Interest rates have been the lowest in history for the last 6 years or so and the stock market has soared during that period. But whenever there is talk about the possibility of interest rates rising, stocks perform poorly. And whenever there is concrete news that interest rates will be kept low, the market goes up.
Look closely at the two charts below from 12/17/2014 and you can see at precisely 2:00 PM, both the Dow and Nasdaq shot up:
What happened was that at 2:00 PM word came from the Federal Reserve that interest rates will be kept low for a “considerable time”. Now, no one knows exactly what a “considerable time” is but investors interpreted it to mean at least for the next 6 months and probably a good part of 2015. In response to the news, investors immediately bought stocks which resulted in both markets shooting up within a matter of minutes.
Why Are Low Interest Rates Good For Stocks?
A big reason is that with rates low, there really isn’t anywhere other than stocks to put your money if you desire a decent return. I have a bank CD and it gets one quarter of one percent interest. Thats .25% and well, that is essentially nothing NOT a decent return! About the only place to go to get that better return is the stock market. So, while interest rates are this low, that means more money will flow into stocks because there is no where else for it to go.
When interest rates are raised (and they will be at some point), people will decide to take some money out of stocks and put it into safe, interest bearing investment vehicles. The higher interest rates go, the more money will come out of stocks and into treasury bills, bank CD’s, and other FDIC insured investments.
But for now, stocks are the only place a person can make money with their money.
A second reason low interest rates are good for the stock market is that they make it cheaper for companies to borrow money. Companies need to have the ability to borrow money for a variety of reasons and the cheaper that money is, obviously the better it is for them (and their investors).
Access to capital is a key to flexibility in doing business and many times borrowing money is necessary. When interest rates are high, companies options may be limited compared to times when money is cheap. Stock investors like low interest rates because that means the companies they invest in will have better flexibility if needed.
So stock investors applaud low interest rates because 1) that means stocks will remain the best investing option and 2) it gives companies of all sizes easier and cheaper access to capital if and when needed.