Yesterday, March 28th, the Fed raised the Fed Fund target rate one quarter of one percent (25 basis points) to 4.75%. This morning when I checked Fed Fund Futures the market had priced a 90% probability that the Fed would raise interest rates another 25 basis points on May 10th. That has been my feeling for some time.
So how do interest rates affect investments? First I will talk about bonds then I will address stocks. Bonds have an interest rate associated with them either as a coupon or as a discount rate. As interest rates rise, receipt of a fixed rate of interest becomes worth less and the price of a bond falls. The longer the time to maturity and the lower the coupon, the greater the price fall for a given rise in interest rates. This concept is called duration.
If a bond has a 4% coupon and interest rates rise to 5%, you would value the 4% less because you can get a 5% coupon at par (100% of face value). So the 4% coupon bond would trade at a discount. The opposite is true if interest rates were falling. The price of the bond would rise. A 4% coupon bond when interest rates were at 3% would sell for a premium.
Interest rates affect stocks in several different ways. First, to the extent that a company uses debt, rolling that debt over will be more expensive. This will compress margins and lower profitability. The amount of free cash flow available to reinvest in growth diminishes and the combined affect is to lower the stock price of the company. The greater the leverage in the company, the greater this impact.
Rising interest rates also affects the relative attractiveness of bonds versus equities. If you can earn a certain 5% yield on a Treasury Bond versus an uncertain 1.2% dividend yield on a stock, a certain part of the investor world will choose certainty.
Rising interest rates affects parts of the economy that are interest rate sensitive like home mortgages, banking and insurance companies. If interest rates go up, mortgages become more expensive and fewer people can afford them. Housing sales slow down and housing construction follows. The manufacturers of furnishings and appliances are hurt. The consumer slows their spending and the whole economy slows down. The makes stock prices fall.
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