Interest rates are currently at an all-time high as central banks such as the Bank of England, the US Federal Reserve, and the European Central Bank aim to bring inflation down to their targets.
In this video we explain how interest rates and the stock market have an inverse relationship.
When interest rates rise, share prices fall and the return available from cash and bonds becomes more attractive.
Watch more...
In this video we explain how interest rates and the stock market have an inverse relationship.
When interest rates rise, share prices fall and the return available from cash and bonds becomes more attractive.
Watch more...
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NewsTranscript
00:00 Interest rates are currently at all-time highs,
00:02 as central banks like the Bank of England,
00:04 the US Federal Reserve, and the European Central Bank
00:07 aim to bring inflation back down to their targets.
00:11 However, there are fears that interest rates
00:13 will stay higher for longer,
00:14 as stubborn inflation takes its time to ease.
00:18 Now, in general, interest rates and the stock market
00:20 have an inverse relationship.
00:22 When interest rates rise, share prices fall,
00:25 and the return available from lower-risk asset classes,
00:28 such as cash and bonds, they become more attractive.
00:31 Because interest rates have remained high for a while now,
00:35 the yield on government bonds,
00:37 they're also refusing to go down,
00:39 which in turn puts pressure on share prices.
00:42 Equities are being challenged
00:44 because investors can instead choose certain UK GILTS
00:47 or US Treasuries and invest in bonds
00:50 that pay more attractive yields
00:52 rather than investing in stocks.
00:54 Now, this is just one of the various ways
00:56 that interest rates can affect stock markets.
00:59 Government bond yields are currently rising,
01:01 as central banks, they back away
01:04 from looser monetary policy,
01:06 and that's taking its toll on shares.
01:08 10-year government bond yields
01:10 are seen as the risk-free rate,
01:12 and any other investment should return more than that
01:15 to compensate for the additional risks.
01:17 Now, the higher the risk-free rate yield goes,
01:20 the less inclined or obliged investors may feel
01:22 to take risk and pay up further asset classes,
01:25 such as shares.
01:26 The 4.27% yield on UK 10-year GILTS
01:31 is the highest since last November,
01:32 and the paper is pushing towards the 4.5% mark
01:36 for only the third time since the financial crisis of 2008.
01:40 Meanwhile, the US 10-year Treasury yield
01:42 is moving back towards the 5% mark,
01:44 a figure only once reached since 2007,
01:48 and that was last October
01:49 when financial markets were running scared of inflation.
01:53 Now, higher rates can also put pressure on stock valuations,
01:56 as corporations may need to generate
01:58 more attractive earnings to capture investor interest.
02:02 Another way the interest rate environment affects stocks
02:05 has to do with a company's bottom line.
02:08 Many firms borrow for the short term
02:10 with debt that resets each quarter.
02:13 Now, the interest on these loans is based on a rate index
02:16 that mimics changes set by central banks.
02:20 So if a debt-issuing company faces higher borrowing costs
02:23 due to rising rates,
02:25 it may result in reduced company growth and reduced profits,
02:28 which can then be reflected in lower stock prices.
02:32 Lastly, interest rates also affect
02:34 the way future cash flows are valued.
02:36 Future cash flows are discounted back
02:38 based on existing interest rates.
02:40 With higher interest rates, future earnings are worthless,
02:44 and therefore, evaluations will be lower,
02:46 and this creates a drag on the stock market
02:49 while they adjust.
02:50 With this said, however,
02:52 there will be some companies that still benefit
02:54 from higher interest rates,
02:55 and we've seen that at the moment with banks, for example,
02:58 and they benefit due to being able to lend at higher rates.
03:02 (air whooshing)
03:05 [BLANK_AUDIO]