How do interest rates impact the stock market?

If you’ve ever spent time tracking the stock market, you know that even the slightest bit of news about a company or its associates can send its stock price skyrocketing or in a tailspin. But few things affect the overall financial markets more than rising and falling interest rates.

That raises the question: How exactly do interest rates impact the stock market?

The short answer is that higher interest rates tend to cause stock prices to decline while lower rates usually help stock prices increase. There are exceptions to these rules, of course, and other factors at play that can impact financial markets. But if interest rates are high, stock prices usually aren’t, and vice versa.

As is the case with most things in the financial world, making sense of interest rates and stock price movements can be a challenge. To help you out, we’ve put together this quick guide that explains how equities prices and the Bank of Canada’s policy interest rates are connected.

Let’s get started.

What Are Interest Rates?

Before we can even start talking about the stock market, we first need to discuss what interest rates are and how they work.

To start, we should define the term “interest rate.” There are various ways to define an interest rate, but the easiest way is to think of interest rates as the amount that a lender charges to people for borrowing money. This interest rate is normally a percentage of the amount loaned (i.e., the principal). In other words, it’s what you pay in exchange for borrowing money.

However, it’s important to keep in mind that there are many, many types of interest rates out there, each of which is used by different types of lenders in order to make a profit from their money-lending business.

For example, credit card companies charge interest on your balance if you don’t pay your card off in full every month. Alternatively, your mortgage lender charges interest on your mortgage in exchange for loaning you the money that you need to buy a house.

But when we talk about interest rates and the financial markets in Canada, we’re specifically talking about the biggest and most important rate of them all: the policy interest rate.

Who Controls Interest Rates in Canada?

If you think the term “policy interest rate” sounds like it’s pretty darn important, you’d be right. The policy interest rate is one of the most important tools that the government of Canada has to be able to effectively regulate our economy.

So, what is the policy interest rate, you might ask?

Well, the whole concept behind it is a bit complicated, but the policy interest rate (which is also called the “overnight rate”) is basically the rate that Canada’s major banks charge to each other in exchange for overnight loans.

Banks often loan each other money in order to ensure that they always have enough funds on hand to cover the next day’s transactions. These banks generally charge each other a standardized interest rate called the policy interest rate on these loans.

In Canada, this standardized interest rate is controlled by the Bank of Canada, which is a crown corporation.

There are many reasons why the Bank of Canada might raise or lower this interest rate. But they generally have to do with the state of the economy, especially with respect to inflation.

If the economy isn’t growing or it’s struggling, the Bank of Canada might lower the policy rate in the hopes that it will encourage people to spend more. On the other hand, if the economy is booming and inflation is getting out of control, the Bank of Canada might raise the policy rate to encourage people to spend less.

All of this rising and falling of the policy rate has large effects on all of our day-to-day lives. There are too many implications of changing policy rates for us to cover here, so we’ll specifically look at how the overnight rate can affect the overall stock market a little later in this article.

Who Controls Interest Rates Around The World?

So far, we’ve briefly discussed how interest rates work in Canada, but it’s important to remember that the Bank of Canada is just one relatively small cog in a much larger global financial system. Most other countries also have central banks like the Bank of Canada that control their interest rates.

For example, in the US, the Federal Reserve is in charge of raising or lowering the “interest on reserve balances.” This is what most people are talking about when they refer to the interest rate in the US.

This same system is used in other countries and in other currency unions. In the UK, the Bank of England controls the national interest rate (called the bank rate). The European system is a bit more complicated as the European Central Bank controls three different interest rates that can affect the eurozone.

But despite differences between how different central banks control interest rates, the end result is the same. Like the Bank of Canada, national banks across the globe can raise or lower interest rates to affect monetary policy and to attempt to rein in or bolster economic growth.

How Do Interest Rates Impact The Stock Market?

We’ve already discussed who controls national interest rates in Canada and abroad, but how do these rising and falling rates impact the stock market?

As a general rule, when central banks raise interest rates, stock prices tend to fall. Conversely, when central banks lower interest rates, stock prices tend to rise.

The mechanics behind how this all works are fairly complicated and they’re not set in stone. Other external events, both within a company and around the world, can have an outsized impact on stock price movement regardless of what’s going on with interest rates.

But the idea is that increased interest rates from the Bank of Canada or other central banks cause the price of doing business to increase.

This is because higher interest rates translate to higher borrowing costs for businesses. When this happens, a company might spend more on getting loans or they might trim down their business expansion plans. If companies slow down their growth due to increased loan prices, it could cause their share prices to fall. Should enough companies have share prices that fall, they could drag down market indices like the S&P/TSX Composite Index in Canada.

Alternatively, when interest rates decrease, the cost of doing business tends to decrease, too. If it’s cheaper for businesses to get loans, they might speed up their plans to expand, which could increase their overall output and help them bring in larger quarterly revenues. As a result, that company’s share prices could rise. If enough companies have increased stock prices, this could cause market indices to increase, too.

Again, keep in mind that the correlation between stock prices and interest rates isn’t perfect. There are many, many other factors that can affect a stock’s price, so there’s no guarantee that all stock prices will fall if rates increase or vice versa.

In fact, many companies in the financial sector actually end up with share prices that stay steady or even increase as interest rates rise.

Companies that deal in inelastic goods and services (i.e., goods and services where an increase in price doesn’t have a major impact on demand) also tend to do well regardless of interest rate increases. This includes companies in the energy, utilities, consumer staples, and healthcare sectors.

Even within industries that are normally highly susceptible to interest rate changes, you can find companies that manage to maintain solid financial returns, even throughout periods of increased national interest rates. These are normally companies that have diversified their own business models or who have built up a loyal consumer base that will continue to buy products and services, even if prices rise.

What Do Interest Rates Mean For Your Investments?

If you’re someone that actively invests their hard-earned money in the hopes of building up a long-term retirement nest egg, the connection between changing interest rates and stock prices might be a bit scary. In fact, it’s totally normal to be concerned that rising interest rates could take a chunk out of your savings.

The good news is that there are ways to hedge your investments against the threat of rising interest rates and other economic concerns. Of course, there’s no guarantee that any of these time-honoured strategies will work, and there’s always a risk of losing money while investing.

But the general guidance from financial experts is that having a well-diversified portfolio that provides you with exposure to stocks across a range of industries plus bonds, commodities, and other asset classes, will give you the best possible chance to escape from rising interest rates relatively unscathed.

That said, the reality is that you probably won’t see your investment balance grow every single year, even if you have a well-diversified portfolio. Short-term volatility can wreak havoc on your investments, no matter how hard you work to build up a well-rounded collection of assets. Taking a long-term view of the markets can help you stay resilient, even in the face of interest rate uncertainty.

If you’re looking for more specific guidance about investing or you want help building your own diversified portfolio, it’s best to speak to a financial professional, like a financial advisor, financial planner, or financial coach. These professionals can work with you to find the best investment strategy for your financial goals, even when interest rates are on the rise.

Interest Rates & Stock Prices: An Imperfect Relationship

The relationship between stock prices and interest rates is imperfect, to say the least. You’ll generally find that rising interest rates lead to lower share prices while falling rates increase the overall value of stocks.

But there are exceptions to every rule and there are many sectors that are more resilient in the face of changing interest rates. The key is to have a long-term investment strategy with a well-diversified portfolio that can help you grow your assets and minimize losses, even in periods of market uncertainty.