What Do Interest Rates Have To Do With Stocks?

This is a question from the radio the other day.  Sometimes I think the longer you stay in a business the further removed you become from those that aren't in your business.  I can't understand my plumber, never mind my doctor so when I heard this question 'what do interest rates have to do with stocks', I realized I was probably doing the same thing so I digress.

Interest rates are set by a countries central bank, here in the US, that is the Federal Reserve.  They set the Fed funds rate which is basically the rate at which banks can borrow money.  Banks in turn, lend that money out after they mark it up for a profit. Simple.

When times are good and getting better, the Fed raises interest rates to slow inflation.
When times are bad and getting worse, the Fed lowers interest rates to spur the economy.

The relation of interest rates to the stock market is not simple, it is very complex to say the least.  When interest rates on fixed income such as CD's, US Treasuries and corporate bonds are relatively high, investors tend to take on less risk which can put pressure on stocks however, increasing interest usually means times are getting better which means public companies profits are stronger and thus their stock price should reflect those profits and increased cash flow.  But corporations borrow money too and increased borrowing costs will affect companies profits and thus their stock price.

As you can see, the relation of interest rates to the stock market is very complex to say the least.  Hopefully this very brief overview has been helpful.


Leverage Is Almost Always A Bad Idea

Warren Buffett
"Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."

-- Warren Buffett, 2010 Berkshire Hathaway Annual Report 

The preceding from Warren Buffett is undeniably true.  

Interestingly, the amount loaned by brokerages to clients to buy more stocks is at an all time high except three weeks before the financial meltdown in 2008.

It's always a great idea to be careful and borrowing money to buy stocks is a terrible idea.