The investment community and the financial media tend to obsess over interest rates—the cost someone pays for the use of someone else’s money— and with good reason. When the Monetary Policy Committee (MPC) of the Central Bank sets the policy rate at which banks borrow from the central bank, it has a ripple effect on the investment ecosystem including the stock market and the entire Ghanaian economy. While it usually takes at least 4-6 months for any increase or decrease in interest rates to be felt in a widespread economic way, the market’s response to a change is often more immediate especially on the borrowing side.
Understanding the relationship between interest rates and the stock market can help trustees understand how interest rate changes can affect investments of their schemes and how to make better investment approval decisions.
The Interest Rate That Impacts Stocks
The interest rate that moves markets is the policy rate. Also known as the discount rate, this is the rate banks are charged for borrowing money from the central bank. The policy rate is used by the Bank of Ghana to attempt to control inflation.
Why is this number, what one bank pays another, so significant? Because the base interest rate—the interest rate banks charge their most credit-worthy customers—is largely based on the policy rate. It also forms the basis for the rates for other consumer and business loan.
What Happens When Interest Rates Rise?
When the MPC increases the policy rate, it does not directly affect the stock market. The only truly direct effect is that borrowing money from the central bank is more expensive for banks. But, as noted above, increases in the policy rate have a ripple effect.
Because it costs them more to borrow money, financial institutions often increase the rates they charge their customers to borrow money. Individuals are affected through increases to loan interest rates, especially if these loans carry a variable interest rate. This has the effect of decreasing the amount of money consumers can spend. After all, people still have to pay the bills, and when those bills become more expensive, households are left with less disposable income.
This means people will spend less discretionary money, which will affect businesses’ revenues and profits.
But businesses are affected in a more direct way as well because they also borrow money from banks to run and expand their operations. When the banks make borrowing more expensive, companies might not borrow as much and will pay higher rates of interest on their loans. Less business spending can slow the growth of a company; it might curtail expansion plans or new ventures, or even induce cutbacks. There might be a decrease in earnings as well, which, for a public company, usually means the stock price takes a hit.
Interest Rates and the Stock Market
So now we see how those ripples can rock the stock market. If a company is seen as cutting back on its growth or is less profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company’s stock.
If enough companies experience declines in their stock prices, the whole market, or the Ghana Stock Exchange (GSE) index also declines. With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable. Furthermore, investing in equities can be viewed as too risky compared to other investments.
However, some sectors do benefit from interest rate hikes. One sector that tends to benefit most is the financial industry. Banks and other financial institutions earnings often increase as interest rates move higher, because they can charge more for lending.
Changes in interest rates can create opportunities for investors. To be able to take advantage or to hedge against these swings in interest rates, your fund managers should be up on their game.