Why Interest Rates matter for Stocks - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 29 June 2013
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- By Asad Dossani, Author, The Lucrative Derivative Report


Asad Dossani
In the last few weeks, stock markets around the world have been very volatile. This is due in large part to the US Federal Reserve deciding that they may soon end their quantitative easing program. If the Fed is buying fewer long-term bonds, it means that long-term interest rates are moving upwards.

In fact, anytime a central bank changes interest rates, or threatens to change interest rates, the stock market moves considerably. Why is this the case? Why is it that interest rate movements have such a large impact on the stock market?

The answer is not as obvious as it seems. When we buy a stock, we are buying a share of that company. This means we are buying into the expected future profits of that company. Do interest rates really affect the company's profits? Unless we are talking about a bank stock, or a stock with a high amount of debt, small changes in interest rates don't have a significant impact on a company's future earnings.

If that is the case, why does the stock price move so much when interest rates change, even though earnings are not affected? There are two main components when it comes to valuing a stock. The first is expected future earnings. The second is the discount rate to which we apply to future earnings.

The discount rate is a measure of how much we value future earnings relative to current earnings. The higher the discount rate, the less we value future earnings, and the cheaper the stock as a result. What this means is that when the discount rate goes up, stock prices fall. Similarly, when the discount rate goes down, stock prices rise. This occurs even when expected earnings do not change.

When interest rates change, this translates directly into a change in the discount rate. When central banks increase interest rates, the discount rate goes up, and then stock prices fall. When central banks decrease interest rates, the discount rate goes down, and then stock prices rise.

This is the reason the markets are moving so much when the Fed even suggests ending their QE program. It has very little to do with the company's expected future earnings. Instead, it is due to the fact that when QE ends, the long-term interest rates will go up, and this translates into a higher discount rate. Thus, we end up with falling stock markets.

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is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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3 Responses to "Why Interest Rates matter for Stocks"

manoj kumar mondal

Jun 30, 2013

More importantly, higher interest rate leads to higher allocation of funds in bonds, resulting less demand for equity. Furthermore, the increasing borrowing cost of equity investors mellow their aggressiveness, resulting less demand. The reverse is also true. Discount rate and consequent impact on valuation is a slow process.

Like (1)

premachandran

Jun 30, 2013

you see share market is actually a ponzi scheme ( except intial offer). The rise/fall in walue of a stock is based on future earnings which no body can really predict. That is why when the discount rate is high people put money in debt. when the discount rate is too bad they try their luck in sharess. In india with interest rates of 9% there is no need for shares. In the west they have interest rates of 1-2%. So they use shares to make some money.

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venkateswarlu

Jun 30, 2013

Very Useful topic for investors. Nicely presented and explained.

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