With the United Kingdom inflation rate above 10% in March 2023, it’s not hard to see the vital role interest rates play in the economy, especially in exerting significant influence on the stock market. Annually, the Bank of England sets interest rates representing the expense incurred when borrowing money from banks. When interest rates rise, borrowing becomes costlier, creating challenges for economic growth. Conversely, borrowing becomes more affordable when rates decrease, providing a stimulus for economic expansion. In this article, we will explore the dynamic relationship between interest rates, the UK economy, and the UK stock market.
Relationship between interest rates and the UK stock market
The UK stock market experiences notable repercussions from fluctuations in interest rates, potentially triggering fluctuations in investment. However, several crucial parameters come into play when considering the intricate connection between interest rates and the stock market. We’ve listed these parameters below.
· High-interest rates
When the Bank of England raised the interest rate to 4.25% in March 2023, the stocks began to perform poorly in the market as it became more expensive for business owners in the UK to borrow money to increase their investments. Consequently, there may be a slowdown in the growth of their investment, forcing companies to cut back on investment and leading to lower earnings and lower stock prices.
Invariably, higher interest rates make bonds more attractive to investors at the expense of stocks, which may shift the weight of the market to bond quarters. Investors will purchase bonds because they offer fixed returns, unlike stocks with uncertainty regarding earnings growth. When this happens, stock prices may forcefully go down as investors continue to sell their stocks and buy bonds instead.
Therefore, investors must keep tabs on interest rates using tools like the economic calendar, which tracks important economic events, to stay informed, make strategic economic adjustments, take advantage of opportunities, and avoid potential threats. If the Bank of England releases interest rate decisions eight times a year, that’s enough frequency to ensure you are always tracking the impact of their decisions on the stock market and other investments.
· Low-Interest rates
In financial markets, low-interest rates create a favourable climate for stocks to flourish and achieve robust performance. The rationale behind this lies in the ease and affordability with which companies can secure loans from banks when interest rates are minimal. This accessibility to capital acts as a catalyst, fostering increased investment and driving economic growth.
Furthermore, the allure of stocks is enhanced when interest rates are low. E. Napoletano, a former registered Financial Advisor from Forbes, advised that at such times stocks gain a competitive advantage over other fixed-income securities, such as bonds. Vitally, this advantage may yield lower returns in a low-interest-rate environment. Investors are drawn to the potential for higher returns offered by stocks, making them a more enticing investment option.
How interest rates affect the Economy
Interest rates can affect different sectors of the economy, with housing and consumer spending being some areas where the impact is mainly felt.
Impact on Dividend-Yielding Stock
Dividend-yielding stocks, particularly those with high dividend yields, can be sensitive to changes in interest rates. When interest rates rise, fixed-income investments become more attractive than dividend-yielding stocks as the relative risk-reward tradeoff shifts.
Investors may reallocate their portfolios, favouring fixed-income assets over stocks, which can put downward pressure on the prices of dividend-yielding stocks. Conversely, when interest rates decline, dividend-yielding stocks may become relatively more attractive, potentially increasing their prices.
The UK Office for National Statistics reported that in the fourth quarter of 2022, consumer spending in the United Kingdom was around £351058 million compared to £350226 million in the third quarter of 2022 during the heat of deflation. Judging by the facts above, interest rates can affect the economy through consumer spending. Consumers can borrow money when interest rates are low to get things like credit cards, car loans, and personal loans. Conversely, high-interest rates make borrowing expensive, reducing consumer spending and slowing the entire economy’s growth. Summarily, as economists expect a further increase in the UK interest rate to 4.5% in May, it’s important to note that these changes in interest rates would influence the housing market, consumer spending, corporate investment, and overall economic growth. Hence, investors need to leverage an economic calendar to keep an eye on interest rates, make informed investment decisions and achieve long-term financial success