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Interest rates are one of the most important factors determining the behaviour of the markets. There is generally an inverse relationship between the market and rates - for example, when interest rates are high, money tends to flow OUT of the stock market, deflating stock prices, because a better return can be had from interest-bearing instruments. Similarly, low interest rates encourage money to flow INTO the markets, inflating prices, because the returns on stocks (dividends and capital appreciation) seem better than the interest that will be received outside the market. Rising interest rates also cause retail sales to fall (it becomes more expensive to borrow for consumer goods, as well as to support a margin account). Falling sales eventually lead to reduced corporate profits, which cause the stock market to fall, and ultimately higher unemployment. When day trading, traders may use interest rate announcements as a sign to stay out of the market until 'the dust settles'. A further consideration is corporate bonds. Riskier than Treasury Bonds, companies borrow money with these instruments by offering above average interest payments on them. The higher interest rates generally, the higher corporate bond rates must become in order to still be competitive. And paying those interest payments (the 'yield') can become crippling for companies in times of high interest rates. Government bodies have control of the 'discount rate' (or 'base rate'), and modify it periodically in order to try and control the economy. The discount rate is the rate at which a country's central bank will lend money to retail banks. They in turn 'mark up' this rate before passing it on to their customers. In recessions, governments tend to ease discount rates in order to encourage borrowing and spending. If inflation starts to get out of control, the discount rate may be raised in order to discourage spending and put the lid back on rising prices. Related topic - T-Bills. These are short term bonds issued by the Government to raise cash.They last only up to 26 weeks, and usually return a good rate of interest relative to interest rates generally. |
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