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How do interest rates affect the stock and bond markets?

Changes in interest rates cause stock and bond prices to go up and down. The trend in interest rates is the key indicator of how the economy is doing.

By understanding the relationship between interest rates and securities prices, you will be in a better position to make informed decisions about your investments.

For example, a rise in interest rates will tend to reduce new home sales because consumers will be reluctant to borrow - and fewer will qualify -- at the new, higher mortgage interest rates. If you own stock in an appliance maker, then you might expect to see the price of your stock fall. Fewer home sales means less demand for refrigerators and stoves.

When rates are rising

High or rising interest rates make stocks less competitive than bonds. This causes investors to take their money out of stocks and put it in bonds. Bonds become more attractive because they offer a higher return through the new higher interest rates. The reduced demand for stocks causes stock prices to fall.

Higher interest costs drive up business operating costs by making borrowing more expensive. This can reduce company profits, driving stock prices lower. Higher interest rates also raise the cost of capital for business investments. Since an investment should earn a greater return than the cost of the money borrowed to make the investment, higher interest rates reduce the number of profitable investments. This reduces business investment.

Less business investment tends to reduce economic growth and hurt stock prices. Similarly, consumer spending on big-ticket items like cars and houses is hurt by high interest rates. A greater share of household income is needed to pay debt charges such as home mortgage payments.

When rates are falling

Falling interest rates generally boost stock prices. This is because stocks look more attractive than lower-yielding bonds. The subsequent increased demand for stocks boosts their prices.