How do interest rates affect the share market?

By Thomas Kidd

Whenever interest rates go up, you can bet there’ll be a lot of discussion about how this will affect homeowners and businesses, but the relationship between interest rates and share prices is a little more mysterious. In this article, we look at the basics of this relationship, and what you should consider when making your next investment decision.

Why do interest rates change?

The Reserve Bank sets the cash rate in Australia, which is the interest rate for overnight loans between financial institutions. Typically, the lending rates of these institutions will correlate strongly with the cash rate, so when the cash rate goes up, so too do the interest rates for loans from the banks.

Changes to the cash rate are not arbitrary; the cash rate is The Reserve Bank’s primary instrument for influencing the rate of inflation. In short, lowering the cash rate will encourage borrowing, leading to increased spending and inflation, whereas raising the cash rate discourages borrowing, leading to decreased spending and lower inflation or even deflation. The Reserve Bank generally maintains a target rate of inflation between 2-3%.

Why do interest rates affect the share market?

Since businesses will often borrow funds to finance an investment project, interest rates have a direct effect on the expected return from a given project. Therefore, when interest rates are high, businesses are less likely to take on new ventures which could increase their profitability and growth due to the increased risk of borrowing. Conversely, investors are less likely to borrow funds to invest due to the costs involved and will seek lower share prices to match the lowered expectations of growth. For consumers, increasing interest rates can mean increasing mortgage payments, and so discretionary spending decreases as a result. All of this applies downward pressure on the share price. In summary, we can say that share prices are generally inversely correlated with movements in the interest rate.

So if interest rates go up, should I sell my shares?

Before you start jumping ship, here are a few important things to keep in mind:

Interest rates aren’t the whole story. While interest rates certainly do affect the price of shares, they are just one of a myriad of factors at play. In fact, while increasing interest rates may slow growth, they are also an indicator of strong economic conditions, which may suggest that prices will continue to rise. In reality, we can’t look at interest rates in isolation as an indicator of where the market is going.

Markets aren’t always rational. The share market doesn’t always represent the ‘fair value’ for a given investment; share prices are constantly changing according to consumer sentiments, and these aren’t always rational. When investors see the share price going down and decide to sell, this can further decrease the share price, but this doesn’t say anything about the actual profitability of the business. A big share sell off can result in heavily discounted share prices, which may get snatched up by more savvy investors.

Shares are a long-term investment. This is perhaps the most important thing to remember. Share prices can fluctuate dramatically daily, and for an amateur investor, making daily buy and sell decisions is akin to gambling. Unless you’re prepared to do the research, you should be prepared to hold your shares for the long-term, rather than making regular trades and trying to ‘beat the market’. Doing so will allow you to weather the day-to-day fluctuations and hopefully achieve long-term growth in your portfolio.

Ultimately, when it comes to making investment decisions, there is no catch-all solution; however, understanding these mechanics of the market can help you make decisions that are right for you.

Thomas Kidd in an authorised representative of Alliance Wealth Pty Ltd. (AR: 001292328)