Interest rates, the Federal Reserve and stock prices

The Federal Reserve is the central bank of the United States, and its main lever is a short-term interest rate that influences borrowing costs across the whole economy. Interest rates are one of the most important inputs into how investors value stocks, because they set the price of money and the return available from safer alternatives. Understanding what the Fed does, and what it does not control, helps you read financial news without overreacting to it.

What the Fed does

Congress has given the Fed a mandate centered on maximum employment and stable prices. Its policy decisions are made by the Federal Open Market Committee (FOMC), which has twelve voting members: the seven governors of the Federal Reserve Board and five of the twelve regional Reserve Bank presidents, including the president of the New York Fed. The FOMC holds eight scheduled meetings a year. After each one it announces a decision, and the minutes are published about three weeks later. Four times a year, participants also publish projections for the economy and the policy rate.

The Fed has three main tools:

• The policy rate. The FOMC sets a target range for the federal funds rate, the rate banks charge each other for overnight loans of reserves.
• The balance sheet. Buying Treasury and mortgage-backed securities (often called quantitative easing) adds liquidity and tends to push longer-term yields down. Letting those holdings shrink (quantitative tightening) does the reverse.
• Communication. Statements, projections and speeches shape what markets expect future policy to be, which is often called forward guidance.

Policy rate versus market rates

The Fed sets only the overnight rate directly. Rates for longer maturities, such as the 10-year Treasury yield, corporate bonds and mortgages, are set by the market. They reflect expected future policy rates, expected inflation and the extra compensation investors demand for holding longer bonds. For background, see how bonds work and bond yields and prices.

This is why a Fed decision that was fully expected often moves markets little. Prices adjust when expectations change, and the surprise matters more than the move itself.

How rates reach stock prices

1. Discount rates. The value of a business is the present value of its future cash flows. A simplified growing-perpetuity formula shows the sensitivity:

Value = next year's cash flow / (discount rate - growth rate)

Example (illustrative numbers). A company is expected to generate $100 million of free cash flow next year, growing 3% a year forever. At an 8% discount rate its value is 100 / (0.08 - 0.03) = $2,000 million. If the discount rate rises to 9%, the value becomes 100 / 0.06 = about $1,667 million, a drop of roughly 17% from a one-percentage-point change. Real valuations are more complex, but the direction and the sensitivity are the same. See discount rate and CAPM for how the rate is built.

2. Borrowing costs. Higher rates raise interest expense on floating-rate debt and on debt that must be refinanced. They lower interest coverage and make leveraged companies more fragile.

3. Demand. Higher rates make mortgages, car loans and business borrowing more expensive, which can slow spending on housing, autos and capital projects. Lower rates tend to support these areas.

4. Competition from safer assets. When cash and Treasury bills pay more, the extra return stocks must offer over safe assets, the equity risk premium, becomes harder to justify at the same prices.

5. Sector effects. Long-duration growth companies, whose profits are expected far in the future, tend to be more sensitive to rate changes. Utilities and real estate carry large debt loads and pay dividends that compete with bond yields. Banks and insurers are influenced by lending margins and investment income, although the effect depends on the shape of the yield curve and on credit quality.

Rules of thumb

The reason for a rate move matters as much as its direction. A cut in a healthy economy and a cut in a recession can have very different outcomes for stocks.

Common mistakes

• Treating "don't fight the Fed" as a law. It is a saying about tendencies, and policy and markets can disagree for long stretches.
• Assuming every cut is bullish. Cuts often arrive when growth is deteriorating.
• Mixing up the policy rate with the 10-year yield or mortgage rates. They can move in different directions.
• Trading the meeting day. Short-term reactions are noisy and often reverse, and the expectations already in prices are hard to see.
• Ignoring the starting point. The same rate move has different effects on a richly valued market than on a cheaply valued one.

Where to see it on StocksXray

The Market Compass gives a market-based read on risk and on the economic regime, and its sector outlook describes how sectors have tended to behave in each setting. These are past tendencies, not forecasts. The yield curve article covers another way that rates carry information.

Key takeaways

• The Fed sets a short-term target rate and shapes expectations; the market sets longer-term yields.
• Rates affect stocks through discount rates, borrowing costs, demand and competition from safer assets.
• Expectations matter more than announcements, so a widely expected move often changes little.
• Long-duration, heavily indebted and dividend-heavy companies tend to be the most rate-sensitive.
• The reason for a rate change matters as much as its direction.