Why Interest Rates Matter To The Stock Market

Updated: May 06, 2024 | Published: May 04, 2024
Verified Investing
By Verified Investing
Why Interest Rates Matter To The Stock Market

There is an inverse relationship between interest rates and the stock market. When rates rise the stock market tends to go down. Investors can see this inverse correlation by just checking interest rates on days the stock market declines.

The reason for this is simple. When rates rise, investors have a choice of a higher return by investing in bonds without the risk of a stock or the stock market. The higher interest rates/bond yields go, the more investors will choose to sell stocks to take the guaranteed interest rate on a bond.

For an example, imagine an investment paying 1% like during the pandemic when interest rates were near zero. Almost no one wanted to invest in bonds for a 1% return and most opted for stocks. While stocks do carry risk, 1% is so low, many hoped they would at least get the average yearly return on the stock market of 6-7%.

Interest rates have climbed near 5% and valuation on stocks are extremely lofty. This makes many investors choose to exit stocks (the risk of investing in stocks) and go for the 5% return.

While most investors still choose stocks, there is always an interest rate that would make someone flip from stocks to bonds. For example, imagine if interest rates spiked to 50%. How many would choose to still invest in stocks. Remember, stocks can decline during bear markets and they average below 10% per year historically.

This explains why interest rates matter to the stock market and why when rates climb, the stock market usually sells off.