Interest Rate and Stock Market Prices - Essay Example

Interest rate and stock market prices Name Institution Course Unit Instructor Date Introduction Interest rate is one of the key macroeconomic performance indicators. It is used as a tool by central banks to influence the economy by dictating the amount of currency in circulation which is visible in form of flow of investments, performance of the stock market and the relative worth of currencies in relation to others. From a microeconomic perspective, interest rate is basically the price of obtaining a loan though such facilities such as mortgages, credit cards or even a simple business loan. Interest rate has also shown a reach into the stock market as a ripple effect through a complex relationship. The impact of interest rate on the stock market In the US, performance of the stock market at NYSE is influenced directly by the activities of Federal Reserve Bank which acts as the American central bank. The bank is charged with the task of setting basic interest rates as part of its role of implementing monetary policies. This interest rate applies in the form of federal funds rate, which is the cost that banks are charged for borrowing money from the Federal Reserve Bank (Fed). However, commercial banks primarily borrow from each other but the fed is usually the lender of last resort. Perhaps one may wonder why banks need to borrow money yet they take deposits and give out loans which are supposed to balance out. The reason why banks borrow money, usually overnight though they can also take a week to mature, is in order to manage liquidity and meet the minimum reserve requirement placed on banks by the Fed (Makiw 2014). The interest charged by the Fed as the lender of last resort influences the interbank interest rates. This way, the Fed gets to control the amount of currency in circulation in the economy. Excessive amount of currency in circulation chasing very few goods can result to inflation. Alternatively, excessive demand with a shortfall in supply leads to inflation which is basically observable in rapid increase in prices of basic commodities (Mankiw, 2014). Therefore, the Fed influences the amount of disposable income available to households and the amount of revenue that firms can get through sales by regulating inflation. Basically put, a high interbank interest rate lowers money supply in circulation and thus makes it more expensive to obtain. Therefore, an increase in the Fed’s funds rate has no direct effect on the stock market. Instead, increased funds rate makes it more expensive for banks to borrow money from the fed and from each other as each bank with excess liquidity seeks to set an overnight lending rate guided by the fed’s funds rate. This way, federal funds affects interbank overnight lending rates, households and businesses. For instance, a higher fed funds rates means high credit card interest rates alongside other loans which means that reduced spending by the households and decreased sales volume for businesses. It also becomes expensive for businesses and investors to access loans to fund new investments. On the other hand, a higher funds rate helps to mop up excess currency in circulation and thus stem inflation (Ma & Sun, 2012). A hike in interest rates appreciates the US dollar against other currencies. This is because the hike increases the yield offered by American assets. This tends to attract foreign investors from other countries. The strength of the reaction in terms of the dollars rates depends on future expectations of changes (Ma & Sun, 2012). For instance, if a further increase in the interest is expected in future, then the reaction will not be as robust when a future drop is expected. In the case of the US, the rate has remained at almost zero with attempts to revive the economy since the 2008 depression. This means that the government sacrifices foreign investment with a desire to boost the economy further from internal funding sources. Given that the funds rate affects both consumers and businesses, it also means that the stock market is affected. This is because consumers are spending less on the products and services offered by the listed companies. The stock price estimates the value of a firm based on its profitability now and in the future. This is done by taking the sum of all the expected future cash flows from that company discounted to the present. The stock price is thus calculated by taking this sum of the future discounted cash flow and dividing it by the number of shares available. This amount fluctuates depending on the performance of the company and expectations in future earnings. In cases of higher interest rates, investors choose between investing money in other ways to gain a higher interest or take the greater risk of buying stocks with interest in form of dividends and stock price appreciation (Ma & Sun, 2012). The fluctuations in earnings and future expectations of earnings result to movement and volatility in the prices of the company stocks. This creates a market environment where there are investors who are willing to invest and some willing to divest by selling. For instance, if a company is seen to be cutting back on growth due to industry changes or even changes in management, then it is predicted that the company’s future cash flow will drop. Such negative expectations impact negatively on the demand of the stock and the price as a smaller number of investors will be interested in the stock. Investors or stock share holders expect to be compensated through dividends for taking the risk. This risk is expected to remain lower than the other risks such as treasury bills. A hike in interest rates increases returns from treasury bills hence a stock should be able to compete or offer higher returns than the ‘risk-free’ treasury bills and bonds (Mankiw, 2014). Nonetheless, it must be noted that the interest rate is not the sole determinant of stock prices. Other factors such as climate, political stability, political regimes among others all influence stock prices. Some factors may affect a specific industry such as petroleum or technology or affect different industries. In that case, when several companies experience declines in stock prices, the whole stock market or index may register a decline. Major indexes in the NYSE include the Dow Jones and S&P 500. The Dow Jones is arguably the oldest and most important index globally and includes companies such as General Electric, Pfizer, Nike, Disney, and Microsoft (Mankiw, 2014). Conclusion The discussion thus shows that interest rates have an inverse relationship with stock market prices. A drop in interest rates increases the performance of the stock market with indexes most likely to report a positive gain. However, any hikes in interest rates must take note of the he ‘risk-free’ which can discourage activity in the stock market and encourage investors to take government securities in form of treasury bills and bonds. References Makiw, N. (2014). Principles of macroeconomics. New York: Cengage Learning. Ma, K. & Sun, Y. (2012). Research on the influence of interest rate regulation on a share market price. Advances in Asian Social Science 3(2): 640-644. Read More