How Do Changing Interest Rates Affect the Stock Market and Different Sectors? 

When it comes to your stock portfolio, you want to make sure that you’re making the most informed decisions possible.

Interest rates are one factor that can have a significant impact on the market, so it’s important to understand how they work and what they mean for your investments.

In this post, we’ll take a closer look at how interest rates affect stocks and what you can do to protect your portfolio in a changing market.

What are Interest Rates and What Exactly Do They Affect?

If you’re already quite familiar with what interest rates are, you can skip ahead to the next section.

If you’re a beginner in the world of finance, however, it’s important to understand what interest rates are on the global economic scale, before we get into how they affect your journey as a stock investor or trader.

Interest Rates at a Personal Level

Chances are you’re familiar with what interest rates are on a personal level – so let’s start with that.

If you’re taking out a loan from the bank to buy a car or home, you’ll be expected to pay back both the principal (the amount of money that you borrowed) plus any applicable interest accumulated.

On the other hand, if you’re putting your money into a savings account, the bank will pay you interest on your deposited funds. This is because they can then use your deposited money to lend out to other people and charge them interest (this is how banks make their profit).

In basic terms, interest is the price you pay for borrowing money.

Interest Rates at a Global, Economic Level

Now, what does this mean on a more global, economic level?

Why Central Banks Lower Interest Rates

Well, when a country’s Central Bank (like the Federal Reserve in the United States) wants to stimulate the economy, they’ll lower interest rates across the board for banks. What this does is make it cheaper for people and businesses to borrow money, encouraging them to spend and invest more. This results in more money circulating through the economy, which can help to boost growth.

Why Central Banks Increase Interest Rates

On the other hand, if a Central Bank wants to slow down an overheating economy, it’ll raise interest rates. This makes it more expensive for people and businesses to borrow money, leading them to spend and invest less. This can help to prevent inflationary pressure (i.e. it stops prices of goods/services from rising too rapidly).

Now that we know what interest rates are on a global economic scale and how Central Banks use them to influence the economy, let’s take a look at how they can affect stock prices.

How Do Changing Interest Rates Affect Stock Prices?

When Interest Rates Increase

In general, when interest rates go up, it becomes more expensive for companies to borrow money. This can lead to lower profits and share prices. It’s also safer for investors to leave their money in the bank earning interest, lessening the demand for stocks and driving the price down.

When Interest Rates Decrease

On the other hand, when interest rates go down, it becomes cheaper for companies to borrow money. This can lead to higher profits and share prices. It’s also hard to earn much interest from bank accounts, so people will look to invest their money in riskier assets such as stocks and property, further driving up the prices.

However, not all stocks are the same – and different stock sectors of the economy will be affected differently by these changes.

How Interest Rates Affect Different Sectors of the Stock Market

The stock market is divided up into different sectors, based on the type of business or industry that the companies operate in.

Some sectors are more sensitive to changes in interest rates than others. Here’s a look at how different sectors are affected:

Sectors Least Affected By Changes in Interest Rates

Utilities

Utility companies such as gas and electricity are typically less affected by changes in interest rates because they’re not as reliant on debt financing. This is because they generate stable cash flow from their customers’ monthly bills.

Consumer Staples

Consumer staples companies, like food and beverage manufacturers, are also relatively insensitive to changes in interest rates. This is because people will still need to buy food and daily supplies regardless of the state of the economy.

Healthcare

Healthcare companies are also relatively insensitive to changes in interest rates. This is because people will still need to receive medical care regardless of the state of the economy.

Telecom

Telecom companies are also relatively insensitive to changes in interest rates. This is because people will still need to communicate regardless of the state of the economy.

Sectors Most Affected By Changes in Interest Rates

Real Estate

Real estate stocks are typically more sensitive to changes in interest rates. This is because they’re often highly leveraged and have large amounts of debt financing. This can be things like Real Estate Investment Trusts (REITs).

Banks/Insurance

Financial companies, like banks and insurance firms, are some of the most sensitive to changes in interest rates. This is because they earn a lot of their profits from lending money and investing in bonds. When interest rates go down, their lending rates also follow suit and this hits their profits hard. The reverse is also true, as rates go up, generally bank profits across the board also rise.

Consumer Discretionary / Cyclical Stocks

Cyclical stocks, like those in the automotive or housing sectors, are also quite sensitive to changes in interest rates. This is because changes in interest rates can affect consumer demand for these products.

Highly-Priced Growth Stocks

Growth stocks are stocks that are expected to grow more than the average company and can come from a wide variety of industries (e.g. Adobe, Nike, Lullemon, Tesla, Uber). Because of this optimism, they’re frequently priced at a premium, and because stock valuations are calculated using existing interest rates as part of the mathematical formula, when interest rates change, valuations can be dramatically altered – leading investors to immediately sell down when interest rates rise for example.

How to Prepare Your Portfolio for Changes in Interest Rates

If you’re worried about how changes in interest rates might affect your stock portfolio, there are a few things you can do to protect yourself:

Diversify Your Portfolio

One of the best ways to protect your portfolio is to diversify your holdings. This means investing in a variety of different stock sectors so that if one sector is affected negatively by changes in interest rates, the rest of your portfolio can offset these losses. You can learn how to do this properly here.

Invest in Defensive Stocks

Another way to protect your portfolio is to invest in defensive stocks. These are stocks that are relatively insensitive to changes in the economy. Utilities, consumer staples and healthcare stocks which we spoke about earlier tend to be good defensive investments.

Rebalance Your Portfolio Regularly

It’s also important to rebalance your portfolio on a regular basis. This means selling off your winners and reinvesting the proceeds into other areas of the market that might be undervalued. By doing this, you can make sure that your portfolio is always well-positioned regardless of what the market is doing.

Keep a Cash Reserve

Finally, it’s always a good idea to keep a cash reserve on hand. This way, if there is a sharp drop in the stock market, you’ll have the cash available to buy up shares at bargain prices just like shopping at the supermarket for discounted produce.

The Bottom Line

Now that you know what interest rates are and how they can affect stock prices, you’ll be able to make more informed investment decisions. Just remember that stock prices can be affected by a variety of factors, so it’s important to do your own research before making any investment decisions.

If you’d like to learn how to do exactly that, I have a couple of resources you may find useful:

Best of luck!

Terry