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How does the interest rate impact stock markets?

Interest is known to most people for its impact on credit, but it also affects investments, directly or indirectly. Some yields, such as fixed income, perform inversely with credit because they benefit from high-interest rates.

The standard interest rate also impacts investments in variable income. Let’s understand how financial institutions calculate this rate and how does interest rate impact stock markets.

What is the interest rate?

The interest rate is an institution’s main element in calculating a client’s interest. Also, they present the interest rate as a percentage in an annual format.

So, for example, an interest rate of 10% means that to borrow, let’s say, 1,000 USD for one year, the client must pay 10%.

The amount actually to be paid is called the interest. The interest the client must pay is 100 USD (1,000 x 10%) in the above case.

Good to know: In the case of a loan, the bank usually calculates the interest monthly.

The general calculation formula is as follows:

Interest = Loan balance x interest rate x Duration / Number of days of the year

If the client repays the loan in monthly installments, then:

  • the duration will be 30 days
  • 360-day calendar year.

The monthly interest calculation formula becomes:

Monthly interest = Loan balance x interest rate x 30/360

In the case of credit agreements, the bank uses the exact number of days of the months (28, 30, or 31, as the case may be) and the year – equal to 365 or 366 days, as the case may be. However, the differences are minor, so the above formula is enough to understand how the loan works more efficiently.

What types of investments are affected by the interest rate?  

The SONIA rate (Sterling Overnight Index Average for unsecured transactions in the British sterling market) affects all financial market investments. The difference is that some are affected directly and others indirectly.

Among the investments directly affected are fixed income. The investment income is linked to the SONIA rate or the CDI rate in this case. At the same time, those indirectly affected do not use the SONIA rate as an index but are impacted by it because the rate influences the entire economy. It is the case with variable income investments.

What happens to investments in a high-interest rate scenario?

When the standard interest rate rises, it puts pressure on the price of financial services such as financing, bank loans, and card fees, among other types of credit. On the other hand, fixed-income investments such as CDB tend to appreciate.

What happens in a low-interest scenario?

Market interest rates tend to fall when the standard interest rate dives. Still, it is necessary to consider that this relationship between the fall in the SONIA rate and the fall in actual interest rates is not always automatic. It may be that the banks do not pass on the SONIA falls in full or take a long time to reduce their interest rates.

In the real economy, low-interest rates favor consumption and production. As a result, people start to buy more with cheaper credit, and companies produce more, increasing employability.

Concerning investments, a low-interest scenario reduces the profitability of fixed income. It may even cause these yields, which have always been a haven for investors in the UK, to register negative returns when discounting inflation. This loss of value of the investment in fixed income can happen in scenarios of meager interest, insufficient to cover the costs with Income Tax and administration fees.

On the other hand, investments in variable income may benefit from the fall in interest rates.

How does interest affect the stock market?

Historically, when interest rates tended to rise, stock prices fell. But on the other hand, when interest rates tend to fall, stock prices tend to rise. So perhaps many are still wondering about the relationship between stocks and interest rates.

Stocks and interest rates are two opposite things. From the company side, the interest rate is the cost of capital. In contrast, from the company side, the interest rate is the opportunity cost (cost of opportunity) from the investor side.

Of course, companies that plan to expand their business (expansion) require additional financing. The financing can come from the company itself, in the form of capital, or seek external sources in loans or debt.

If the company obtains financing from debt, then the company must bear the interest expense from the loan, which will affect the company’s net profit. So, when interest rates rise, the company’s net profit is expected to fall due to rising interest expenses and vice versa.

Any increase or decrease in the company’s net profit will immediately affect the price of its shares on the stock exchange. So, if the company’s net profit is estimated to fall, its share price will also tend to fall, and vice versa.

In addition, the increase in loan interest rates may hamper the company’s expansion activities. As a result, the company did not realize its higher profit forecast, and subsequently, the share price fell.