If you’ve been watching the news lately (as of this writing, it’s September 2019), you might be seeing a lot of headlines about the “Feds lowering interest rates again” or “interest rates at an all-time low.” You might also see the other headlines that indicate a market downturn or even a recession, as interest rates continue to be driven down.
As more of this enters our newsfeeds, we know it raises questions, like “What’s the connection between interest rates and the markets?” and “What does this have to do with me?” To explain all of that, first, we have to talk about what an interest rate is, what the federal interest rate is, and how both affect businesses.
WHAT DO INTEREST RATES HAVE TO DO WITH THE ECONOMY?
Interest rates, as you know, are what you’re charged when you borrow money. On top of paying back the amount, you’re charged interest, which accrues over the life of the loan on the existing balance. To explain how federal interest rates affect the market, let’s share a simple example:
Think about a personal car loan. How much difference would a 0.5% interest rate versus a 5.0% interest rate affect your personal budget? Let’s say the value of your car is $20,000. At 0.5% for 68 months (the average length of a car loan), you’d pay about $298 a month. Now, at the 5.0% rate for the same car and term, you’re looking at $338 a month.
On this scale, an extra $40 a month doesn’t seem to matter, but let’s scale that up a bit.
The big businesses represented on the stock exchange are borrowing money at interest rates — and amounts — much higher than this personal car loan example. When federal interest rates go up, it can affect how much money businesses can borrow, and how much they’re paying for that same loan. As you’d expect, higher federal interest rates mean higher bank loan interest rates and higher payments, which means lower profits and less money for growth. And as we all know, business profits and growth are part of what make the market (and your investments) go up.
WHAT ELSE DO FEDERAL INTEREST RATES AFFECT?
Of course, when we talk about “federal interest rates,” we aren’t just talking about the rates that banks charge. These rates stem from the Federal Reserve, which increases or decreases the federal funds rate to control how much money is or is not available. Confused? Don’t worry!
Basically, the Federal Reserve reduces the federal funds rate to allow for more money to flow into banks and markets. This means banks can offer more loans to more businesses (and people) at a lower rate. More money available at lower rates means — hopefully — more growth and more money coming back in as people pay their loans (plus interest) back.
The federal funds rate also affects the prime interest rate — the interest rate that banks charge. Of course, this affects mortgage loans, credit cards, and other consumer and business loans. When those interest rates are down, more people will take out loans and will have more disposable income, thanks to the lowered payments on their existing debt.
So, federal interest rates going down is a sign that businesses can borrow more and, in general, generate more profit. People have more disposable income and can save, invest, and spend more. And more profit leads to higher stock values, which means the stock market is going up … right?
Not always.
WHAT THE FEDERAL INTEREST RATE DECREASES MEAN FOR THE MARKET
When the Feds announce they are decreasing interest rates, it’s generally a sign that there will be more spending (and more profit) to flow through the economy. This can lead to confidence in the market and an uptick in shares, investing, etc. However, if there is some stunted expansion in the market, like we’ve been seeing in 2019, the market may see interest rate decreases as a sign of concern over the economy.
Because, when things are good, the Feds don’t need to release as much money. When things aren’t so good, they have to loosen the reins a bit and lower the rates so more businesses (and people) can afford to borrow. This, in theory, is meant to stimulate the economy. Coupled with other concerns about the market, though, a Fed interest rate decrease usually causes turmoil in the stock market.
So, should you be worried about the Feds decreasing interest rates?
HOW THE FED INTEREST RATE AFFECTS YOU
The reality is: the market is a mental game. Pulling out of investments that aren’t growing at the same rate, or selling when the market in general has a downturn, can prevent you from gaining the massive rewards when the stock market goes back up. As long as you have time, a dip in the market can be a very good thing. Shares become cheaper, you can buy more, and you can watch your investments increase in value as the market goes back up. When the Feds lower the interest rate, it’s a great time to assess your bond-to-stock allocation, as well as your risk tolerance.
If you want help from a team of CERTIFIED FINANCIAL PLANNER™ professionals, contact Guiding Wealth. We’ll help guide you through market changes and how to invest given the current climate.