The insights in this article will enable you to clearly foresee the stock market’s direction in the months and years ahead by showing how the availability of money affects the stock market.
I will guide you through the last 60 years of economic data comparing the Federal Reserve Prime Rate and the S&P Composite Index, so you can assess the current state of the economy and, therefore, the stock market direction.
How Do Interest Rates Affect The Stock Market?
Interest rates affect the stock market in two ways. A long-term prime interest rate below 5% encourages economic expansion, which is seen in stock market growth. A high-interest rate stifles investment and causes the economy and stock market to contract. Equally important is the direction and speed of interest rate changes. Rapid interest rate increases cause stock market volatility and decline; rapid decreases can encourage quick recovery.
Firstly, we start with a brief understanding of Monetary Policy.
Video: Interest Rates vs. The Stock Market Explained
Monetary Policy Controls Interest Rates
“Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.”
Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as being an expansionary policy or a contractionary policy, where an expansionary policy increases the total supply of money in the economy and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation.
“Monetary policy is contrasted with Fiscal policy, which refers to government borrowing, spending, and taxation.”
OK, so that’s the painful bit out of the way. Let’s look at what that really means:
- Supply of money, availability of money, and cost of money (Prime Interest Rate) are essentially controlled by governments or government-appointed Central Banks.
- These factors are used to try to ensure economic stability.
- Using a lower cost of money and higher availability of money, a government can stimulate economic growth. This means stimulating business and lowering unemployment which equals stock market growth and real estate growth but may increase inflation.
- Increasing the cost of money via interest rates or restricting the supply of money can be used to combat the inflationary pressures in the economy, but this usually has a knock-on effect of making it more costly to borrow; therefore, companies get a lower return on the capital invested and lower profits. This drives down stock prices, real estate prices and increases unemployment.
60 Years of Interest Rates vs. The S&P Composite Index
Figure 1 shows you exactly how monetary policy affects the stock market by overlaying the U.S. Prime Interest Rate on the S&P500 returns from 1954 through October 2009.
What is the prime rate? The prime rate is the cost for businesses or consumers to borrow money. The rate published is usually the rate for favored customers with a lower risk profile; if your risk profile is higher, you may have to pay a higher interest rate.
The prime rate is important because if a company has 80% of its capital from bank loans and has a 5% profit margin. Imagine, what would happen to the company profits if interest rates went from 5% to 15%? The company’s profit margin might be reduced by 2% or nearly halved if all things remained equal.
Therefore a company may seek to maintain profit margin by reducing its costs and attempting to pay back some of the debt. More often than not, reducing cost often comes in the form of reducing people; therefore, unemployment increases. Companies could also increase the cost of the product or service they provide; however, this might lead to fewer sales and less profit, so they would need to shed staff anyway.
S&P500 Index vs. the Federal Reserve Prime Rate Example
We can see clearly in this chart what the biggest influence over the stock market direction is.
- The mid to late ’70s saw stock market stagnation. Then the cost of money was reduced in the form of Interest Rates. A Prime Rate above 10% has contributed strongly to a stagnant stock market at least, or at worst, a period of serious decline.
- The vigorous Prime Rate reductions in the early 1980s sparked a huge Bull Market.
- Continued low-interest rates and a surge of cheap credit-fuelled an economic Boom that lasted up to 2000, bar the 1987 crash, which really looks like only a blip compared to the overall advance.
- Rates were again reduced while the economy boomed.
- Rates increased slightly to try to reduce overheating but were kept under 10%. This had no significant effect on the stock market or the economy. The Prime Rate was slowly increased for the five-year period before the 2000 Dotcom crash. Prime Rate was used to try to slow down the Developed World from overheating. It worked.
- The unrealistic expectations in the economy and in the stock market fuelled to insanity by the Internet and Technology Stocks Boom had to burst. This is the idea of the Bubble bursting.
- As the bubble burst, the Central banks reduced interest rates to halt the further dangerous decline. Three years later, the market eventually bottomed and began to resume the usual upward trend.
- Rates slowly increased again to try to prevent overheating. This time it did not work.
Something quite different happened in 2008 to cause one of the most violent global stock market crashes since the Depression. This time it was not the cost of money but the money supply, the other factor mentioned in our definition of Monetary Policy. The availability of money was severely restricted because of a lack of trust between the financial institutions. None of the institutions knew who had how much exposure to the Sub-Prime Market that was at the time collapsing. Therefore the banks stopped lending to each other, drastically reduced lending to businesses and the consumer. This caused a much quicker and more devastating effect on the economy than slowly increasing interest rates could have done. This was akin to somebody just turning the lights off.
- Related Article: How Interest Rates Affect Bank Stocks
What Is A Good Interest Rate For Stocks?
60 years of research shows that interest rates below 10% are good for stock market returns, below 5% produces strong stock market performance, and close to 0% produces economic crisis recovery and stock market booms. The availability of cheap money through low interest rates creates speculation in property, stocks, and commodities, which must be controlled with good financial oversight and regulation.
Will Stocks Fall When Interest Rates Rise?
My analysis shows that slow increases in interest rates over multiple years, that remain below 5% will not cause stocks to fall dramatically. Any large increases in interest rates will immediately affect property prices and cause the balance sheets of companies to contract, affecting stocks.
The most common causes of stock market crashes are not interest rates, but poor institutional risk management, easy access to credit, and equity bubbles.
Live Chart: Federal Funds Prime Rate.
Here is a live chart of the Federal Reserve Prime Rate. Remember, rapidly increasing interest rates, especially above 5% will cause stock market declines.
 “Monetary Policy.” Federal Reserve Board. January 3, 2006. http://www.federalreserve.gov/policy.htm.
 B.M. Friedman “Monetary Policy,” International Encyclopedia of the Social & Behavioral Sciences, 2001, pp. 9976-9984