Relationship Between Interest Rate & Investment

Image Credit: Jupiterimages/BananaStock/Getty Images

A business obtains cash by issuing equity or acquiring a loan. When a business borrows money, it typically commits to the repayment of a principal amount and the payment of interest at a certain time.


Investors concern themselves with interest rates, as well as the interest rate and investment relationship, because they directly influence the returns they earn on their investments, such as bonds. Also, interest rates directly and indirectly influence a company's net earnings, which directly affect stock returns and prices. What's more, the interest rates influence consumer market behavior or demand, which also affects the company's earnings and stock prices.


Video of the Day

In general, the higher the interest rates, the lower a company's earnings and stock prices.

The Federal Funds Rate

The federal funds target rate (FFR) is set by the seven Federal Reserve Board governors and the five Federal Reserve Bank presidents, the combination of which is termed the Federal Open Market Committee. The FRR is the interest rate that one bank pays to borrow cash from another bank.


Within 12 months after the announcement of a new federal funds rate, the change begins to impact the U.S. economy, including stock and bond markets.

The Federal Reserve Discount Rate

The Federal Reserve also sets the interest rate that the Fed charges to loan money to banks directly, which is referred to as the discount rate. As a disincentive to borrowing from the Federal Reserve, rather than another bank, the discount rate is higher than the federal funds rate.


The FFR and the Stock Market

The federal funds rate influences the prime interest rate, which is the rate a commercial bank charges its more credit-worthy customers. The FFR also heavily influences the credit card annual percentage rates, mortgage rates and other interest rates. As the rate rises, demand falls.


Consequently, the federal funds rate is a mechanism that the Federal Reserve uses to control inflation by shrinking the money supply. When the availability of cash decreases, the cost of borrowing increases.

In turn, if the federal funds rate decreases, the money supply increases. In response, interest rates fall and businesses and individuals borrow more money and issue more debt and stock.


The Effect of Declining Interest Rates

The Federal Reserve cuts the federal funds rate to stimulate financial activity when the economy slows. Investors consider lower interest rates to be a catalyst for business growth via new operations, acquisitions and expansions, which spurs corporate borrowing. Increased funds lead to increased profits and a thriving economy.


In that companies begin to finance operations with funds they borrow at a relatively low interest rate, business earnings increase as do stock prices. What's more, lower interest rates lead to increased consumer spending.

Interest Rate and Investment Relationship

As the Federal Reserve increases the discount rate, the cost of administering short-term loans for a financial institution increases. These increased costs are passed on to the borrower, both individual and institutional, in the form of higher interest rates. Because financing operations with borrowed funds with a relatively high interest rate, business earnings fall as do stock prices. In addition, higher interest rates lead to decreased consumer spending.


Interest Rates and Stock Market

Interest rates relate to the stock market in an inverse way. If interest rates rise, it's typical for stock prices and earnings to fall and vice versa.

Consequently, investors keep one eye on the Federal Reserves as a cut in interest rates will lead to an increase in stock prices and earnings and an increase in interest rates will lead to a decline in market prices. There is, however, no means to determine the dollar effect of any interest rate change on a share's value.


Interest Rates and Bond Market

A change in interest rates impacts the bond market as well as the stock market. When interest rates rise, bond prices fall. The result is an increase in the yields of existing bonds, which brings the yields of those bonds in line with the bonds issued with higher coupons after the rise in interest rates.

The longer the bond's term, or the longer its maturity, the greater its fluctuation in response to changes in interest rates.