The question of what happens to stocks when interest rates rise is straightforward, but a single, definitive answer is certainly more elusive.   Other factors such as individual company performance and the type of industry can have a significant impact on how some stocks will react.  The degree and timing of rate increases as well as investors’ expectations also play a role in driving the stock market’s reaction to increasing rates.

The Federal Reserve typically raises rates in periods of stronger economic activity, which is when stocks are also doing well.  To help control resulting inflation, the “rate” that the Federal Reserve targets is the federal funds rate, which is the interest rate that banks charge each other for overnight loans.  This short-term borrowing/lending is done to satisfy the minimum reserve requirements that banks have to keep on hand, and it impacts the pricing of other loans.  If the Fed is raising the rate, the goal is to push the cost of borrowing higher and make it more expensive to buy larger ticket items like homes or cars or even operate a business and thereby slow down economic growth (vice versa if lowering rates).

The Federal Reserve has held the rate near zero for several years as part of an effort to strengthen economic activity after the last recession, but now that course of action is subject to change.   Although GDP has been mired in a slower growth pattern compared to previous recoveries, it is still improving. Other signs of strength include the continued drop in the unemployment rate from 10% to well under 5% and there has been an increase in the employment cost index (measure of wages, benefits).  Continued momentum could eventually drive up inflation that, along with lower unemployment, may lead to a path of successive rate hikes.  However, the Fed has so far increased the federal funds rate by just 0.25% (in December 2015) and continues to be very accommodative with its monetary policy.

An increase in interest rates can cause stocks that have bond-like characteristics (significant, regular dividend payouts and stable prices) such as preferred stocks or utilities to decrease in value.  However, the opposite tends to be true for financial firms like insurance companies and banks, as those companies can achieve increased earnings in a higher rate environment as they invest in higher-yielding investments or earn a greater spread over what they pay depositors.  Additionally, individual company performance can offset rate pressures as stocks of companies that are experiencing very strong, profitable growth will likely experience increasing share prices despite rising interest rates.  So while rising interest rates typically mean falling prices for bonds, that same correlation is not as strong for stocks.

The stock market’s propensity to anticipate economic trends, fiscal and monetary policy and other factors mean, at the very least, that their timing and degree of impact on the stock market will be difficult to discern.   Because timing the market is difficult, a more prudent approach for investors is to use time horizons, risk tolerances and objectives when investing and revisit portfolio allocation regularly.