How do interest rates affect the stock market?

Interest rates and the stock market aren’t directly connected. But increases or decreases in interest rates can noticeably affect stocks and not necessarily in ways you might expect. Here’s what you need to know.

What are interest rates?

Interest rates are an amount that borrowers are charged by banks and other financial institutions on the money they borrow, or savers are paid on the money they save, typically expressed as a percentage of the amount borrowed or saved.

Banks and the like can choose the interest rates they charge on loans and pay on deposits, but these interest rates are often heavily influenced by that set by a country’s central bank. This rate is the interest rate the central bank pays to commercial banks that hold money with it. In the UK, this is the Bank of England base rate (also known as the “Bank Rate”). In the US, for example, it’s a rate set by the Federal Reserve.

How is the Bank of England base rate set?

As the name suggests, the UK’s base rate is decided on by the Bank of England. A team of financial experts reviews the rate regularly and decides what the base rate should be. The state of a country’s economy, and in particular the level of inflation, can greatly impact base rate decisions.

When do interest rates change?

That depends on the specific interest rate you’re talking about.

The Bank of England’s monetary policy committee (MPC) meets 8 times a year to discuss and set the UK’s base rate. That’s roughly every 6 weeks. But that doesn’t necessarily mean that the base rate changes this often. In fact, the base rate can stay the same for years at a time. Until December 2021, the base rate had been set at a steady 0.1% for nearly 2 years. And there have been longer periods of static base rates previously.

But, in times of economic turbulence, things can change much more frequently as the Bank of England attempts to stabilise the economy. During 2022 and 2023, inflation has been high in the UK, so the bank has made frequent base rate hikes in an attempt to bring inflation back down to its target of 2%. As of February 2023, the base rate was 4%.

Financial institutions that lend money or hold deposits can set their own interest rates and change them whenever they want. However, to be competitive and attract customers (as well as to reflect their own costs), the rates are often heavily influenced by Bank of England base rate changes. So, we often see banks adjusting their advertised interest rates shortly after a base rate change.

How do interest rates affect stocks?

There’s no direct link between interest rates and the value of stocks. A change in one won’t automatically trigger a change in the other. However, changes in interest rates do have the potential to affect other factors which can, in turn, influence the value of stocks. These include:

• A higher cost of borrowing for businesses if interest rates rise. Businesses that rely on low-cost loans to grow, particularly where the loan rates are not fixed and are therefore subject to increases in central bank rates, may overall perform less well financially. This may result in stock prices falling for such companies.
• Consumers having less disposable income in a high-interest-rate environment due to the higher cost of borrowing. This can affect the demand for non-essential goods and services and, therefore, the success (and stock value) of the companies delivering those goods and services.
• How shares are valued. A share’s current value indicates what investors think a company is worth and what they are willing to pay for it today based on anticipated future value. This is calculated using a process called discounting. It converts a future value into today’s value by dividing it by something called a discount rate. Without going into too much complex detail, higher interest rates mean higher discount rates. And this means the calculations suggest a lower future value. This is particularly important for growth stocks, typically in newer companies, purchased for their anticipated high future value.

Do any stocks go up in value when interest rates go up?

If interest rates are increasing gradually and the economy is strong, the impact on stocks is likely to be minimal to non-existent. But, the factors we’ve outlined above mean that, typically, stocks go down in value when interest rates go up more than you might expect in a strong, stable economy. It’s not always a direct correlation, though, depending on the specific stocks.

Stocks in suppliers of non-essential goods and services and/or growth stocks are more likely to see their value hit when interest rates climb. Suppliers of essential goods and services are likely to weather any effects better. And, in fact, banks and other financial institutions may even do quite well out of it, as higher interest rates enable them to charge a higher rate on loans without necessarily having to increase rates they pay on deposits.

Value stocks, which are stocks in well-established companies that pay stable dividends, may also be a less risky bet in a high-interest rate environment. They’re typically more stable and less reliant on taking out loans to deliver as a business.

What happens to stocks when interest rates fall?

Just as rising interest rates can make stock values fall, the inverse is also true, and falling interest rates have the potential to cause stock values to rise. Though, as with the opposite, it depends on the specific stocks and what else is going on with the company and the market at the time.

Can rising interest rates hurt the stock market?

Potentially, yes, if the cumulative impact of rising interest rates causes a large number of companies to perform less well than expected. Or, indeed, if the appetite for investors in buying higher-risk growth stocks causes a large number to instead invest in lower-risk alternatives, such as bonds.

But not every stock will fall in value, and this may be enough to even things out. And, even if the stock market suffers a temporary setback, this doesn’t mean all is lost. Remember that investing is for the long term, and time and time again, markets have been proven to recover from short-term setbacks.

What affects stock value other than interest rates?

The value of stocks in a company, and in some cases, the stock market as a whole, can be subject to multiple influences that impact supply and demand. These can include (though are not limited to):

• Company news and announcements. This may be expected (a report confirming a significant loss or profit, for example) or unexpected (such as the death of CEO).
• Economic factors. These include interest rate changes but also other factors relating to the economic or political situation in a country – such as a change of government.
• Industry trends. If a sector performs well overall, it’s likely to positively impact all companies that operate in that sector (and vice versa). Think, for example, of the boom for tech companies during the coronavirus pandemic.
• Natural disasters. These can cause business disruption, limit its access to supplies and potentially increase its debt.
• A change in the number of shares available. This could be caused by a company releasing new shares or buying back shares, or by lots of investors selling their shares at once. Share prices tend to be higher when the supply of shares is low and lots of investors want to buy.

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Bottom line

There are lots of factors that can affect the stock market and, indeed, your own investment portfolio. Interest rates are just one of them and may not necessarily have the impact you might expect. You shouldn’t change your investment strategy just because of concerns about rising or falling interest rates. Instead, take a measured approach that looks at the bigger picture and takes account of your long-term investment goals. If in doubt, seek professional financial advice before making any decisions that could affect your financial future.

Frequently asked questions

• What happens to stocks when interest rates rise?

  Typically, interest rates and stock values tend to move in opposite directions. When interest rates climb, stocks fall and vice versa. However, it’s not quite this black and white in practice, with different types of stock being affected in different ways and a wide range of other factors also having an impact.

• How do interest rates affect bonds?

  There’s a strong correlation between bonds and interest rates. When interest rates rise, demand for bonds falls and the price tends to drop. However, bond issuers must try to appeal to buyers, so the bond returns — or yield – is likely to increase. The reverse typically happens when interest rates fall.