Why Do Lower Interest Rates Drive Stock Prices Up?
The European Central Bank (ECB) is widely expected to cut interest rates for the first time since 2019 on Thursday (by the time you read this newsletter, perhaps the decision has been made). At the time of writing, investors in Asia are starting to react. Many Asian stock markets are going up with hopes that the ECB will pull the trigger and boost market sentiment.
Here are 5 reasons why stock markets react positively when interest rates are down:
Lower borrowing costs. If an investor can borrow money cheaply with lower interest rates, they would borrow and use the funds to invest in stocks for higher return. That will create fresh demand for stocks and drive the market upwards. On the business side, companies can also borrow cheaply when interest rates are lower. This allows businesses to take out loans at lower costs to invest in expansion, operations, and other growth initiatives, which can lead to higher future earnings.
Increased consumer spending. Lower interest rates typically mean lower mortgage and loan rates for consumers. With more disposable income, consumers are more likely to spend, boosting company revenues and profits. That expectation will trigger investors to buy up more shares with the expectation that profits will grow and make the stocks look cheap today.
Investment shifts. Lower interest rates will reduce the returns on fixed income assets like bonds. As these investments become less attractive, investors often shift their money into stocks, seeking higher returns. This increased demand for stocks drives up their prices.
Valuation Impact. This reason is a little bit more technical. Stocks are often valued based on the present value of future earnings. Present value is calculated as future earnings dividend by a discount rate. Lower interest rates decrease the discount rate used in these calculations, increasing the present value of future cash flows and, thus, stock prices.
Market sentiment. Lower interest rates are usually a sign of a central bank's efforts to stimulate the economy. This can boost investor confidence, leading to more buying in the stock market.
The first 4 reasons will require more time for the gradual effect to play out. But market sentiment is exactly what is driving the stock markets up today.
Here are 5 reasons why stock markets react positively when interest rates are down:
Lower borrowing costs. If an investor can borrow money cheaply with lower interest rates, they would borrow and use the funds to invest in stocks for higher return. That will create fresh demand for stocks and drive the market upwards. On the business side, companies can also borrow cheaply when interest rates are lower. This allows businesses to take out loans at lower costs to invest in expansion, operations, and other growth initiatives, which can lead to higher future earnings.
Increased consumer spending. Lower interest rates typically mean lower mortgage and loan rates for consumers. With more disposable income, consumers are more likely to spend, boosting company revenues and profits. That expectation will trigger investors to buy up more shares with the expectation that profits will grow and make the stocks look cheap today.
Investment shifts. Lower interest rates will reduce the returns on fixed income assets like bonds. As these investments become less attractive, investors often shift their money into stocks, seeking higher returns. This increased demand for stocks drives up their prices.
Valuation Impact. This reason is a little bit more technical. Stocks are often valued based on the present value of future earnings. Present value is calculated as future earnings dividend by a discount rate. Lower interest rates decrease the discount rate used in these calculations, increasing the present value of future cash flows and, thus, stock prices.
Market sentiment. Lower interest rates are usually a sign of a central bank's efforts to stimulate the economy. This can boost investor confidence, leading to more buying in the stock market.
The first 4 reasons will require more time for the gradual effect to play out. But market sentiment is exactly what is driving the stock markets up today.
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