When Interest Rates Rise

When Interest Rates Rise

Share prices can increase as long as rates go up gradually

To ward off inflation during times of a growing economy, the Federal Reserve Board of the U.S., the nation’s central bank, typically raises interest rates. The FED can push up the federal funds rate – what banks pay to borrow from each other – and the discount rate – what banks pay to borrow money from the FED. As interest rates rise, money becomes higher, keeping inflation in check. Low inflation, economists believe, paves the way for sustained economic growth.

What happens to stock prices when the FED hikes interest rates? The common belief is that higher rates ultimately produce lower stock prices as investors pull out of the stock market and put their money into other investments. Studies show that a sell-off of stocks usually follows an announcement of a hike in interest rates.

But researches also have shown that stocks bounce back after investors realize that the increase will do little harm to the economy. Often the rate hike helps the economy because consumers speed up interest rate dependent purchases of goods such as cars and houses. Researchers have studied the 13 periods during which the FED has raised interest rates since World War II. They found that in the 12 months after the federal funds rate began to rise, the total return for the Standard & Poor’s 500 was 11.6 percent, a respectable increase.

The stock market can weather a modest rate hike. (Tribeca Park). Photo: Megan Jorgensen (Elena)

True, stocks had a better showing before the FED’s tightening, when the Standard & Poor’s 500 was 18.7 percent. But the historical average gain of 11.6 percent argues for sticking with the stock market even after rates start rising. As long as increases in the federal funds rates are small and gradual – no larger than a quarter of a point at a time, for example p the stock market continues to push higher.

A rising discount rate, however, can spell trouble for stocks. Researches show that prices take a downturn in the months immediately following a discount-rate increase. Total performance after twelve months was a weak 1.5 percent gain. The good news: Discount rate increases are fairly infrequent and generally don’t come for some time after the FED’s initial tightening, giving stock market investors the chance to rack up gains