Question

When the Fed changes the interest rates how does it affect the bond market and the stock market? Do you expect lower or higher interest rates in the near future? Why?

Minimum of 500 words.

Answer 1

Stock market impact:

When the FED cuts interest rates, it lowers the cost of capital for the businesses which reduces their cost of funding, resulting in higher profitability. Also, lower cost of capital encourages demand for loans for investments so businesses expand their capacities through new investments by taking loan at cheap interest rates. Higher investments results in more assets which means possibility of more revenues and earnings for the company. This also creates more jobs which in turn increase aggregate demand in economy, overall demand and income rise. All this leads to earnings growth of the company which reduces the valuation multiples resulting in more fresh buying into stock markets. Accordingly, stocks go higher levels when there is reduction in interest rates. You can see the similar trend in the current scenario; the stocks are going up because of low interest rates. These low interest rates are creating enough money supply in the market which is pushing prices higher and we expect this trend to continue. In addition, low interest rates reduces investment yields in other asset classes, so they also shift money towards equities which means we also see shift of investments from other asset investment to stock equities, resulting in higher demand for shares which also take the market to higher levels. Sometimes very low interest rates are not good as it may indicate likely higher inflation in future which may negatively impact demand. Also, low interest rates also indicate current weakness in demand which may not rise when conditions are worse.

On the other side, when US fed raise interest rates, we see the opposite trend as businesses reduce investments because of higher cost of capital which results in lower business growth. To compensate the impact of decline in business growth, the companies turn to layoffs which results in decline in income levels in the country resulting in lower demand which again impacts businesses, so this vicious cycle continues during high interest rates.

Bond market Impact:

Interest rates have usually inverse relation with bond prices because decline in interest rates results in increase in demand for existing bond as they are currently offering higher coupon rates so low interest rates raises demand for current bonds which results in rise in the prices of the bond and lowers the current yield and yield to maturity.

On the other hand, rise in interest rates results in decrease in demand for existing bond as they are currently offering relatively lower coupon rates so higher interest rates reduces the demand for current bonds which results in decline in the prices of the current bond and aves way for the higher the current yield and the yield to maturity.

Outlook on future interest rates:

In near future, interest rates are expected to remain low given the weak demand conditions due to the covid-19 related lockdowns. We expect interest rates around 0% levels till 2023 end as also indicated by the US Federal reserve in its latest monetary policy meeting held last month.