Q

How do interest rates affect my investments?

A

The short answer is that fluctuations in interest rates can indirectly affect a public company's stock price, which can affect your investments.

There is a good reason why there’s so much yammering on financial news shows interpreting every hiccup and new haircut of the country’s Federal Reserve Chair. It’s because the Fed chair is the person most responsible for setting what’s called the Federal Funds Rate, which is the Fed-set interest rate at which banks loan money to one another. Any tiny movement of this rate will have a massive rippling effect through the economy — and major effects on your investments.

There are a number of reasons why this is. When the Fed raises rates it does so in order to control inflation by effectively limiting the supply of money circulating in the economy. The effect is that it costs everybody — including public companies — more to borrow money. If it costs companies more money to borrow money to expand their businesses, they might either slow their expansion or be forced to spend extra money servicing loans. Either of these scenarios might negatively affect their corporate earnings, causing the share price to fall. If enough companies’ share prices falls, you’ll see overall lowering of major stock market indices like the Dow Jones Industrial Average or the S&P 500, and these drops will either slow your portfolio’s growth, or precipitate some losses. (From a stock perspective, rate hikes are only welcome news for bank stocks, since banks will inevitably benefit from the increased revenue that comes with higher interest rates.) When interest rates rise, the economy usually slows down as well, since some of the consumers who might otherwise blow their money on Bali vacations and Maseratis have to use that money to pay higher mortgages.

Conversely, when the Fed cuts rates, money to borrow is more readily and cheaply available, stocks tend to rise, and consumers celebrate by making it rain wherever they go, and you too will cheer when you see big overall gains in your portfolio. For reasons that are quite well spelled out here, rising interest rates also drive down the prices of existing bonds, while falling interest rates conversely push them higher.

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