Interest rates and the stock market
Guide Summary
- Interest rates influence borrowing, saving and investment behaviour across the economy.
- Rising rates generally cool the stock market, while falling rates can support higher valuations.
- Investors should stay informed and consider asset allocation strategies to navigate rate changes effectively.
What are interest rates?
Interest rates are basically the price of borrowing money, or the reward you get for saving it. In the UK, the Bank of England sets something called the base rate, which influences how much banks charge on loans or pay on savings.
For example, if the base rate is 5%, your bank might offer a mortgage at 6% or a savings account at 4%. When rates go up, borrowing gets more expensive, but saving becomes more rewarding.
Why do central banks change the interest rate?
Central banks, such as the Bank of England (UK), Federal Reserve (US) and European Central Bank (EU), adjust interest rates to keep inflation under control. They do this to try and maintain economic stability.
- If inflation is rising too fast, rates are increased to cool spending.
- If the economy is slowing, rates are lowered to encourage borrowing and investment.
The goal is to strike a balance by encouraging growth without letting inflation get out of hand.
How is the interest rate set?
In the UK, the Monetary Policy Committee (MPC) of the Bank of England meets around eight times a year to review economic conditions and vote on the base rate. They consider:
- Inflation (measured by CPI)
- Employment data
- Economic growth (GDP)
- Global market conditions
The rate they set affects everything from mortgage repayments to business investment decisions.
What happens to markets when interest rates rise?
Higher interest rates usually have a cooling effect on the stock market. This can include:
- Increased cost of borrowing, which can reduce company profits and consumer spending.
- Growth stocks, especially in tech or early-stage companies, often fall as future earnings are discounted more heavily. Understand growth investing.
- Bond prices typically drop as new bonds offer better yields, making older ones less attractive.
Some sectors, like banks through savings accounts and products, may benefit, but overall, rising rates can signal tighter financial conditions.
What happens to markets when interest rates fall?
Falling interest rates usually encourage investment and spending. This can include:
- Companies can borrow more cheaply to grow operations.
- Consumers may spend more as loans and mortgages become affordable.
- Stocks often rise, especially in growth-focused industries.
Lower rates tend to push investors to seek better returns in the stock market as savings accounts offer low interest rates.
How can investors adapt to interest rate changes?
Adapting to interest rate shifts is key to managing risk and opportunity when it comes to investing. Some steps investors can typically take are:
- Diversify across various asset classes to reduce sensitivity to rate movements.
- Research and consider dividend-paying stocks or defensive sectors (sectors that typically provide essential goods and services that consumers will continue to purchase regardless of the economic climate) during periods of high rates.
- When rates fall, growth stocks and longer-duration bonds may offer better returns.
- Review your investment time horizon: short-term savers may prefer fixed-income products, whilst long-term investors could ride out market cycles and potential, although overall investing is for the medium to long term (5 - 10 years+).
Being aware of how monetary policy affects asset prices can help investors stay aligned with their goals.
Interest rates and investing impact summary
Interest rates are a powerful economic lever that directly and indirectly shape the investment landscape.
For new investors, understanding their effects is a crucial building block for making smart, informed decisions. Learn about investing basics here.
Next up: learn how stock markets tend to behave during a recession, and what that means for investors.
When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation. Diversifying means spreading your investments across different sectors, countries and asset classes.
