Question

Explain why low interest rates make housing stocks and other related stocks attractive.

Answer 1

Monetary Policy involves changing interest rates to try and influence aggregate demand and target low inflation and high growth.

If inflation was increasing above the governments inflation target, they would increase interest rates to reduce inflationary pressures.

The Affect on Housing

Higher interest rates increase the cost of mortgage interest rate payments. Therefore, it makes it less attractive for people to buy a house. If interest rates increase too much, some people may not be able to afford their mortgage payments and default on their mortgage. This means they will have to sell their house. This effect will be to reduce demand for houses and therefore lead to lower house prices.

The Affect on Shares.

Higher interest rates could lead to slower economic growth and this may lead to lower share prices. Lower growth will lead to lower profits and lower dividends making shares less attractive. Also higher interest rates make bonds and securities relatively more attractive than dividends from share prices.

However, the impact will be much less than in the housing market because interest rates don’t directly affect the cost of holding shares (like a mortgage which is directly related to interest rates).

Also, higher interest rates will not always cause lower share prices as there are many factors which affect share prices in addition to interest rates. Share prices depend on market confidence, expectations of future growth and general market sentiment. Often stock market sentiment is not related to current economic conditions like the 1987 stock market crash in the middle of an economic boom.

What Happens When Interest Rates Fall?

When the economy is slowing, the Federal Reserve cuts the federal funds rate to stimulate financial activity. A decrease in interest rates by the Fed has the opposite effect to a rate hike. Investors and economists alike view lower interest rates as catalysts for growth – a benefit to personal and corporate borrowing, which in turn leads to greater profits and a robust economy. Consumers will spend more, the lower interest rates encouraging them to feel they can finally afford that new house or send the kids to a private school; businesses will enjoy the ability to finance operations, acquisitions and expansions at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices.

How Do Interest Rates Affect the Stock Market?

Interest rates, the cost someone pays for the use of someone else's money, tend to obsess the investment community and the financial media – and with good reason. When the Federal Open Market Committee (FOMC) sets the target for the federal funds rate at which banks borrow from and lend to each other, it has a ripple effect across the entire U.S. economy, not to mention the U.S. stock market. And, while it usually takes at least 12 months for any increase or decrease in interest rates to be felt in a widespread economic way, the market's response to a change (or the news of a change) is often more immediate.

Understanding the relationship between interest rates and the stock markets can help investors understand how changes might affect their l

Impact of Interest Rates on Stocks:-

And by the way, nothing has to actually happen to consumers or companies for the stock market to react to interest-rate changes. Rising or falling interest rates also affect investors' psychology – and the markets are nothing if not psychological. When the Fed announces a hike, both businesses and consumers will cut back on spending; this will cause earnings to fall and stock prices to drop, everyone thinks – and the market tumbles in anticipation.

. On the other hand, when the Fed announces a cut, the assumption is that consumers and businesses will increase spending and investment, causing stock prices to rise – and the market jumps for joy.

However, if expectations differ significantly from the Fed's actions, these generalized, conventional reactions may not apply. For example, let's say the word on the street is that the Fed is going to cut interest rates by 50 basis points at its next meeting, but the Fed announces a drop of only 25 basis points. The news may actually cause stocks to decline – because assumptions of a 50 basis point cut had already been priced into the market.

The business cycle, and where the economy is in it, can also affect the market's reaction. At the onset of a weakening economy, the modest boost provided by lower rates is not enough to offset the loss of economic activity, and stocks continue to decline. Conversely, towards the end of a boom cycle, when the Fed is moving in to raise rates – a nod to improved corporate profits – certain sectors often continue to do well, such as technology stocks, growth stocks and entertainment/recreational company stocks