Interst Rate Effects on the Stock Markets

Today the Dow Jones Industrial Average dropped 1.2% and the NASDAQ dropped 2.1%. This was attributed mostly to the Federal Reserves recent decision to raise interest rates. But what does that mean? How do interest rates effect the stock market anyway? I’ll try to answer.

A large component of a stock’s price is tied to the expected earnings of the corporation. Analysts forecast the future growth prospects of a company and designate buy or sell recommendations based on their research. This can seem strange to people at first. For instance, company XYZ might increase their revenues (and net income) by 33% and the stock price still drop. Why? Because analysts might be expecting an increase of 34%, and if the stock price is priced with the expectation of 34% growth then anything less could cause the stock price to drop (potentially).

This brings us back to the interest rate question. By and large interest rate increases curb growth. Organizations are less likely to finance projects through loans since the interest payments will increase. Customers also tend to cut back on spending in times of interest rate hikes which can cause higher mortage payments, higher credit card payments, and other increases in a family’s budget.

To put it simply:

interest rates go up -> less cash available to borrow -> less spending -> company earnings do down -> stock prices drop