How Interest Rates Affect Equity Markets?

Interest rates are a determinant factor in the pricing mechanism of public markets. When interest rates go up, the cost of borrowing increases, and this affects economic activity and company profits. Equity markets are sensitive to changes in interest rates because they affect corporate profitability and the cost of capital.

There exists an inverse relationship between the interest rates and equity markets; it is explained by three effects that decrease firm valuations:

Lower future dividends as rising interest rates increase the expenses of the firm and decrease cash flows available to shareholders.
Increased future expected real interest rates which decrease the present value of future nominal cash flows to equity holders.
Increased expected excess returns, also known as the equity premium, associated with holding stocks.

Reference [1] examined the impact of interest rates on the US equity market in detail. Specifically, it divided the broad SP500 into 11 underlying sectors of Technology, Health Care, Financials, Consumer Discretionary, Consumer Staples, Industrials, Energy, Real Estate, Utilities, Materials, and Telecommunication Services; it then regressed each sector against the implied yield. The authors found that,

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Our empirical study on the impact of interest rates on the broader stock market and each of the 11 GICS sectors supports the current consensus among academic literature of a negative relationship between the two variables. In exploring the sensitivity of the equity market to the term structure of interest rates, our findings suggest that investors should pay more attention to the 10-year yield than yields of other maturities as the 10-year has the most significant relationship with the S&P 500. The investigation on each of the 11 GICS sectors further supported the initial hypothesis of a negative relationship, with only the Energy sector exhibiting a positive relationship over the analyzed period. As expected, the Technology sector was the most sensitive to a negative valuation change following an increase in rates, and the Financials sector was the least negatively impacted of the 10 sectors which have historically fallen as a result of higher rates.

In short, the 10-year interest rate has the most effect on the equity markets. All the sectors, except Energy, exhibit a negative relationship with interest rates with Technology and Financial being affected the most and the least respectively.

References

[1] Lee, Raymond and Zhardanovsky, Adam, The Impact of Interest Rates on Different Equity Market Segments (2022). https://ssrn.com/abstract=4087920