What is the impact of the interest rate on the stock markets?

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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 securities, perform inversely to credit as they benefit from high interest rates.

The standard interest rate also has an impact on variable income investments. Let’s understand how financial institutions calculate this rate and how the interest rate impacts stock markets.

What is the interest rate?

The interest rate is the main element of an institution in calculating the interest of a customer. 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, say, $1,000 for a year, the customer must pay 10%.

The amount actually payable is called interest. The interest the customer has to pay is 100 USD (1000 x 10%) in the above case.

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

The general calculation formula is as follows:

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

If the client repays the loan in monthly instalments, 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 month (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 sufficient to understand how the loan works most effectively.

What types of investments are affected by the interest rate?

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

Among the investments directly affected are fixed income securities. Investment income is linked to the SONIA rate or the CDI rate in this case. At the same time, those indirectly concerned do not use the SONIA rate as an index but are impacted by it because the rate influences the entire economy. This 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 like the CBD tend to appreciate.

What happens in a low interest rate scenario?

Market interest rates tend to fall when the standard interest rate dips. It should still be considered that this relationship between the fall in the SONIA rate and the fall in real interest rates is not always automatic. Banks may not fully pass on the fall in the SONIA or may be slow to lower their interest rates.

In the real economy, low interest rates promote consumption and production. As a result, people start buying more with cheaper credit, and businesses produce more, increasing employability.

Regarding investments, a low rate scenario reduces the profitability of fixed income securities. It may even cause those yields, which have always been a safe haven for investors in the UK, to post negative returns when adjusted for inflation. This loss in fixed income investment value may occur in low interest scenarios, insufficient to cover the costs with income tax and administration fees.

On the other hand, variable income investments can benefit from falling 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. On the business side, the interest rate is the cost of capital. On the other hand, on the side of the company, the interest rate is the opportunity cost (opportunity cost) on the side of the investor.

Of course, companies planning to expand their operations (expansion) need additional funding. Funding can come from the business itself, in the form of equity, or seek external sources in the form of loans or debt.

If the company obtains debt financing, then it has to bear the interest expense of the loan, which will affect the net profit of the company. So, when the interest rates increase, the net profit of the company is expected to fall due to the increase in interest expense 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. Thus, if the company’s net profit is estimated to be lower, its share price will also tend to fall, and vice versa.

In addition, rising interest rates on loans could hamper business expansion activities. As a result, the company failed to meet its higher earnings forecasts and subsequently the stock price fell.

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