The capital markets give a reflection on the general status of the economy in any given country. One way to make an assessment on the economy status is the direction and rate of interest rates fluctuations. The Federal Reserve increases or reduces the interest rates so as to control inflation or ease the process of borrowing money. Most banks will follow the guidelines of the Federal Reserve. The fluctuations affect the capital markets and investors need to understand how the markets are influenced.
Borrowing costs
The profitability of a company will determine the stock prices. The company’s profits are affected if it has to pay more in interests in order to borrow capital. If investors suspect that the company many not be able to recover the profits that were used to pay the interest, the cost of stocks could go down. Investors are keen on company profits when the interest rates are high to see if the price of the stock has gone up due to the longstanding presumptions of interest rates. However, when the interests are low, the assumption is that companies can borrow money cheaply. In return, investors will feel that companies will not spend too much money on paying for interests and thus the stock price goes up.
Capital expenses
When the interest rates are high, some companies may halt their plans to invest in large assets. The company may find it necessary to borrow capital to acquire these assets. These companies may be hesitant to commit to this high interest liability that is brought about by acquiring large properties and equipment. Most business purchase assets to generate more income, and the decline in more assets acquisition may mean a decline in income generation thus affecting the growth of the company. When investors feel that the company they have put their money in has stagnated, they may want to dispose off their shareholding and this may cause a decline in stock prices. In case the interest rates reduce, then the company can now invest in these assets, thereby increasing their potential of income generation and drive the stocks prices to a higher level.
Cash flow
The current cash flows and projected cash flows affect the decision of some investors. The cash flow of a company can be affected by high interest rates because most of their money will be spent on paying off this interest. The possibility of having the cash flow reduced could lead to a reduction in stock prices. The entire capital market could have reduced stock prices if several companies report a possible reduction in cash flow and majority of investors will have an expectation of reduced cash flow for most companies due to the high interest rates. On the flip side, when the interest rates are lower, it means companies have surplus amounts to conduct their core business, thus increasing the cost of shares and most investors are happy to pay an extra coin for a profitable and promising investment.
Expectations
It is not automatic that high interest result directly in low prices in stocks and similarly, low interest rates does not result in high profits for the companies and possible high prices in stocks. It is a good business decision in investors feel that the Federal Reserve increases interest rates to reduce inflation as the prices in capital markets could rise and vice versa, if investors feel the Federal Reserve is reducing interest rates to increase inflation, the prices in capital markets will decline.
