After carrying out your first few transactions in the stock market, you may now be fairly familiar with the general concepts involved in trading. For most stock market investors, monitoring the status of their shares is almost a routine procedure. In this article, we are going to shed light on how the increase in interest rate can have an effect on the stock market. Part of being a smart trader is the need to stay up to date with the current events, global financial news and all the pertinent factors that can affect the market. It is imperative for you to remain in a growing position and as such, you must remain vigilant so you can manage your shares accordingly.
What is interest rate?
The interest rate is a common financial term that describes the quantity you need to pay an interest on the money you borrowed. For example, you owe the bank $2,500 and they charged you $125 in interest. Given these figures, you could deduce that the interest rate the bank charged to your debt is 5%.
When it comes to the stock market, the interest rate has a slightly different meaning. It refers to the federal fund rate set by the Federal Open Market Committee (FOMC). Also known as overnight rate, it is the predetermined limit that financial institutions can borrow from the Federal Funds Reserve.
How does interest rate work?
This concept is the government’s strategy to prevent huge brought about by the sudden increase or decrease in the price of goods and services. When inflation happens, it cannot suddenly hit hard on the economy. So how does it control the financial situation?
In case of an inflation (price hike, low supply), the Feds increase the interest rate, making it harder for people to borrow money from banks. This, in effect, lowers the demand as consumers have less money to spend. In case of deflation (price drop, excess supply), the Feds decrease the interest rate which gives consumers higher purchasing power and encouraging them to buy more products.
How can an increase in the interest rate affect the stock market?
Simply put, there is no direct correlation between interest rate increase and the stock market’s position. But the consequences of increased interest rate considerably influences in the market’s overall situation. Whenever the Feds increase their interest rate, banks and other financial institutions have to adjust their own interest rates. The increased interest charged to them will be passed on their clients.
The most easily affected by this increase are companies who loan from the banks. When interest rates increase, businesses tend to avoid borrowing money from financial institutions. Either they borrow fewer funds or do not borrow at all. With less money to spend on their operations and growth, businesses earn less as well. For companies who offer publicly traded stocks, the result of the interest increase will be apparent in their stock value.
Consumers also experience indirect effects of this. For example, when the banks charge higher mortgage or credit card interest, customers think twice if they want to proceed with borrowing money from the bank. Dispensable money is what traders use to invest in stocks. If they have less cash on hand, they cannot carry out trade transactions.
What can you do to avoid too much loss when interest rates increase?
The best course of action for a cautious trader is to diversify his or her portfolio. It is a general rule that you should not put all your eggs in one basket. Having a backup plan when one sector fails will mitigate risks and protect you against huge losses. Do you want to know more about protection from risk-exposure? Check out our stock investing book called ‘Stock Trading Made Simple‘ packed with all the information you need to be a smart trader.