The Stock Market and Interest Rates-Caribbean Value Investor

Whether an individual considers himself a long-term investor or a short-term day trader,  he/she is typically putting money into stocks with the overarching goal of seeing that money grow. One can experience actual pain from seeing his/her portfolio decline significantly regardless of whether that loss is realised or unrealised. It therefore makes sense for us to understand one of the key external market factors that could put a serious damper on the value of our stocks, interest rates. Based on the last two months of policy rate decisions, it is safe to say that we are at the end of the rising interest rate environment. Given that context, and more importantly, the history of the last ten (10) years, I thought it would be useful to introduce you, the aspiring value investor, to the relationship between interest rates and the stock market. Having participated in the market over the last ten years, I think I can add a useful perspective. Nevertheless, I will illustrate the relationship using data from the Jamaica Stock Exchange and the Bank of Jamaica from 2013 to 2024. So let’s discuss the stock market and interest rates.

Why is there a relationship between the stock market and interest rates?

The short answer to this is Risk! Remember in the opening paragraph when I said that investors and traders participate in the stock market to make more money? Well in doing so they are taking a risk. Investors would like to take the least amount of risk they can and get the best returns they can. We will discuss the concept of risk-adjusted returns in a future article. For now, let’s continue to evaluate why there is a relationship. By now, you already know how the stock market works so let’s look at the other part of the relationship, interest rates. Interest rates are set by the Central Bank, in the case of Jamaica, that is the Bank of Jamaica or the BOJ. Most countries have a Central Bank but the most popular ones are the Federal Reserve Bank (The Fed) in the United States, the Bank of England in the UK, the Bank of Canada, the Bank of Japan (also called the BoJ) and the People’s Bank of China (PCB). Central Banks control interest rates and use it as a tool for controlling inflation. They also issue investment instruments known as treasury bills and certificates of deposits. These investments function very similarly to bonds in that they mature at set dates and pay a particular interest, known as the coupon. The higher the interest rates on these instruments, the more attractive they are to investors. Investors will therefore decide to invest more of their money into these instruments when the rates are high and invest less in other forms of investments. They may even sell other investments that are perceived as more risky and “park” their monies in the Central Bank’s instruments since they are generally perceived as less risky. This is why there is a relationship between the stock market and interest rates.

What is the relationship between the stock market and interest rates?

The academic relationship between interest rates and the stock market is inverse. This means that as interest rates decrease, the stock market (index) is expected to increase. Historically, this relationship holds true, as illustrated in the graph below.

As you can see from the graph, in 2013, when the BOJ interest rate was just over six per cent (6%), the JSE Main market Index was just under 100,000. As the BOJ Index rate came down, the Main Market index trended upwards. Eventually, interest rates reached a low of 0.5% in 2019 coinciding almost perfectly with the JSE Main market index hitting its highest level of 523,740.  Similarly, as the interest rate started to climb between 2021 and 2022, the JSE Market Index fell. The BOJ raised interest rates in response to rising inflation spurred by the Covid-19 pandemic and as this happened stocks fell.

What is likely to happen now that Interest rates are coming down?

I think we are at a very interesting place where we are starting to see interest rates come down. If history is any indication, then it is likely that we will see stock prices start to recover. Moreover, as interest rates come down, the yields on fixed-income instruments, both government and corporate are likely to decline and given that stocks prices have already been declining for some time, we could see stocks start to move back up.

The Bottom Line

There is an inverse relationship between interest rates and stock prices.

1. As Interest Rates increase, stocks become less attractive and investors tend to buy government instruments or Central bank certificates of deposits. Stock prices fall as a result.

2. As interest rates come down, the interest paid on government securities and central bank certificates of deposits will be lower, and so investors tend to shift towards stocks and alternative assets hoping to get better returns. The impact of this increased demand for stocks pushes stock prices (and stock market indexes) up.

DISCLAIMER:

The opinions expressed in this article are solely those of the authors and are in no way intended to reflect management’s views. Further, all information provided on Caribbean Value Investor is strictly for educational purposes. Caribbean Value Investor, its Directors, Employees and Stakeholders accept no liability in respect to gains or losses experienced by readers.

The Bottom Line