Despite the last few years (ie up to 2010) being a period of worldwide low interest rates, people are generally unaware of how these rates affect the share markets. For them, they think that any change in the official rate will affect how much money the bank will give them each year for their savings or how much more or less they can spend on their credit cards. However, interest rates have a much wider affect on the financial markets
The most important single factor in this modern economy is the interest rate. In the UK, the base rate is set by the Bank of England at noon on the first Thursday of each month. The figure quoted will tell the banks and large companies how much they can borrow money for, which in turn tells the other banks and credit societies how much they can charge people and smaller companies for borrowing money. In the end, everyone pays more than the base rate.
So how does this affect share prices? The int. rates have numerous effects on the share markets around the world. Here are some things to consider:
a) Most companies borrow money to expand – For example, a company may borrow $1 million dollars at 5% interest a year. This means that each year, the company will owe $50000 in interest. If this company uses this borrowed money to buy a new machine or a new shop that produces a profit of $70 000, then the company makes a profit of $20 000. If the interest rate falls to 3%, the company owes $30 000 a year, which means their profit is now $40 000. The flow-on effect of this rise in profits means an increase in share value. But what if the interest rate rises to 10%? The company now owes $100 000 in interest. Therefore, it is spending $100 000 to make $70 000..opps! If a company starts to lose money or make less profits, the share price will fall.
In summary, rising rates mean less profits for companies because it becomes more expensive to borrow money, which in turn lowers share prices. Lower rates mean money is cheaper to borrow, so more profits are made and higher share prices result.
b) Most people borrow money to buy expensive goods – When interest rates rise, people have to put more money into mortgages and/or pay more for purchases made with a credit card, which means there is less money left over (called disposable income) to purchase other goods. If people purchase less, the companies make less profits, which in turn lowers the share price. When rates fall, people have more money in their pockets to spend on goods and services, which leads to higher profits and share prices. In times of a bad economy, governments will recommend interest rates be lowered to “stimulate” people to spend more.
c) Company payouts look better with lower interest rates – Let’s say you bought a share for $1 and it paid a dividend of $0.05, which is a return of 5%. If the bank base rate falls to 4%, you will only get $0.04 for a dollar in the bank. Therefore, when int. rates fall, share dividends are more attractive and therefore boost demand, which leads to higher share prices.
d) Lower rates mean the next time a company needs to borrow money, it won’t have to pay the bank as much. This means that the company can continue to expand, which increases profits and share prices.
Therefore, you can see from this short article that interest rates have a much wider affect on people’s lives than what is in their bank accounts. If you predict that these rates are going to fall, investing in shares is a great idea. However, if you feel that the rates are too low and are going to rise, it may be a good time to sell the shares.