Hot Features
Premium
Register to chat with like-minded investors on our interactive forums.
For the last two years, the central banks tried to cushion the effects of the corona pandemic on the economy with wide-open floodgates. As a result, growth and the labor markets have regained a foothold after almost two years. Still, at the same time, inflation has returned after years of slack, which is putting monetary authorities under pressure. In short, the phase of zero or even negative interest rates, including securities purchases, is coming to an end.
After the Bank of England raised interest rates, the US Federal Reserve will initially halt its bond purchases this year and then follow up with several rate hikes. The situation is somewhat different in the eurozone, where the ECB has only announced a hesitant reduction in monetary policy support but has not ruled out first-rate hikes over the year. Whether this actually happens, this year depends on how inflation develops.
Let’s learn more about the relation between interest rate and stock markets and how it affects investors.
Difficult phase on the stock market
After the profitable previous year, the stock markets stumbled at the beginning of the year due to increasing fears of inflation and interest rates. The technology sector, previously the driving force behind the upswing, has fallen under the wheels and has lost 14 percent since the high record in November as measured by the Nasdaq 100 index. Why are rising interest rates holding back stocks in general and growth stocks in particular?
Companies hold back with investments, for example, in new technologies or software, since higher interest rates are due for new loans or loans with flexible interest rates. Then there is the logic of the financial markets: in the case of growth stocks, ample profits lie in the future and have a lower value in the present when interest rates are higher.
The so-called value stocks, which grow more slowly but are more cheaply valued, are likely to have better cards than technology and growth stocks. Banks should even benefit from rising interest rates. Nonetheless, the Fed’s forthcoming rate hike cycle will leave its mark. Stock markets usually suffer around the first interest rate hikes but then regain their footing. Nevertheless, a mixed year for stocks is to be feared.
Higher interest rates devalue old bonds
The declining monetary policy support from the central banks has also caused turbulence in the bond markets, which will likely face a difficult year this year. Why? On the one hand, the central banks are phasing out their securities purchases or curtailing them, which means that their artificial demand is gradually falling away. In addition, when interest rates rise, new, higher-yielding bonds are opposed to old ones with lower annual interest payments. Investors are therefore switching to the new debt securities, which is why the old ones are falling – not a good development for existing bond investors. And for new investments, interest rates are still quite low. Many investors have indeed withdrawn from government bonds in recent weeks, which has pushed up their yields. In the US, however, ten-year bonds only yielded 1.75 percent per year at the beginning of 2022 – which is well below the high US inflation.
In principle, rising interest rates for savings deposits are positive. However, the ECB will first reduce the penalty interest on bank deposits before raising the key interest rate as the basis for interest on savings. It remains to be seen whether that will be enough to fuel competition between banks when it comes to their interest rate offerings.
Summary
A long-term connection between interest rates and share price development is obvious. Prices rise when interest rates fall. Therefore, it can be assumed that interest rates will have an impact on share prices. However, this does not apply equally to every interest rate level.
Share prices rise most strongly when two conditions come together: interest rates are below 3%, and interest rates are falling. However, over the past 20 years, stocks have risen even when interest rates have risen.
Rising interest rates take away liquidity from the stock market in times of high-interest rates. On the other hand, the withdrawal of liquidity in times of low-interest rates only plays a subordinate role – especially since financial markets have been flooded with liquidity in recent years.
