Why Interest Rates Are Important to the Stock Market
The stock market (and, more importantly, the companies represented there) uses capital (money) for fuel.
Capital is not free for companies to use.
Companies pay for capital one of two ways:
When a company sells shares of stock in the public markets, that piece of ownership can then be traded among investors.
It is important to note that once a company sells a share of stock on the open market it no longer receives any benefit (or loss) if the share of stock rises or falls in price.
Companies, especially young, growing enterprises, often issue (sell) stock as a way to raise money to fund growth.
The benefit of selling shares of stock is that the company does not have to pay the money back.
If a company doesn’t want to give up ownership by selling stock, it must borrow the money it needs to fund growth.
There are many sources of money for companies to use:
Borrowed money must be repaid, so the company must be certain the funds will improve business enough to generate cash for loan payments.
When interest rates are low, companies often use low-cost borrowed money to fund growth.
However, in a market where interest rates are high, it may not make business sense to borrow money.
When regulators keep interest rates low, they are trying to encourage businesses to expand and create new jobs.
If the economy expands too quickly (inflation) thanks to low loan rates, regulators may take steps to drive up interest rates and slow down borrowing and expansion.
It’s not unlike how you might plan a vacation. If gasoline is inexpensive, you may decide a long vacation trip is a good idea.
However, if gasoline is expensive, you may decide to stay closer to home.
If you think of interest rates as fuel for the economy, low interest rates encourage borrowing, while high interest rates discourage expansion.
Capital is not free for companies to use.
Companies pay for capital one of two ways:
- They can give up part ownership and sell shares of stock
- They can borrow it
When a company sells shares of stock in the public markets, that piece of ownership can then be traded among investors.
It is important to note that once a company sells a share of stock on the open market it no longer receives any benefit (or loss) if the share of stock rises or falls in price.
Companies, especially young, growing enterprises, often issue (sell) stock as a way to raise money to fund growth.
The benefit of selling shares of stock is that the company does not have to pay the money back.
If a company doesn’t want to give up ownership by selling stock, it must borrow the money it needs to fund growth.
There are many sources of money for companies to use:
- Bank loans
- Bonds
- Equipment financing
- And others
Borrowed money must be repaid, so the company must be certain the funds will improve business enough to generate cash for loan payments.
When interest rates are low, companies often use low-cost borrowed money to fund growth.
However, in a market where interest rates are high, it may not make business sense to borrow money.
When regulators keep interest rates low, they are trying to encourage businesses to expand and create new jobs.
If the economy expands too quickly (inflation) thanks to low loan rates, regulators may take steps to drive up interest rates and slow down borrowing and expansion.
It’s not unlike how you might plan a vacation. If gasoline is inexpensive, you may decide a long vacation trip is a good idea.
However, if gasoline is expensive, you may decide to stay closer to home.
If you think of interest rates as fuel for the economy, low interest rates encourage borrowing, while high interest rates discourage expansion.
