The investment community and financial media tend to obsess over interest rates and for a good reason. Interest rates refer to the cost someone pays for the use of someone else's money.
When the Federal Open Market Committee , which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents, sets the target for the federal funds rate—the rate at which banks borrow from and lend to each other overnight—it has a ripple effect across the entire U.S. economy, including the U.S. stock market.

KEY TAKEAWAYS

When the Federal Open Market Committee changes the interest rate, it impacts both the economy and the stock markets because borrowing becomes either more or less expensive for individuals and businesses.
Any impact on the stock market to a change in the interest rate changes is generally experienced immediately, while, for the rest of the economy, it may take about a year to see any widespread impact.


The Interest Rate That Impacts Stocks

The interest rate that impacts the stock market is the federal funds rate. Also known as the discount rate, the federal funds rate is the rate depository institutions are charged for borrowing money from Federal Reserve banks.
The Federal Reserve makes adjustments to the federal funds rate in order to control inflation. By increasing the federal funds rate, the Federal Reserve is effectively attempting to shrink the supply of money available for making purchases.

Below is a chart that shows fluctuations in the federal funds rate over the past 20 years:1?

The federal funds rate is significant because the prime interest rate—the interest rate commercial banks charge their most credit-worthy customers—is largely based on the federal funds rate.

What Happens When Interest Rates Rise?

When the Federal Reserve increases the discount rate, it does not directly impact the stock market. The only direct impact is that borrowing money from the Federal Reserve is more expensive for banks. The impact is due to the fact that any increases in the discount rate have a ripple effect throughout the rest of the economy.
Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So, individuals consumers are impacted through increases to their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.
Consumers still have to pay their bills. When those bills become more expensive, households are left with less disposable income.

What Happens When Interest Rates Fall?

When the economy is slowing, the Federal Reserve cuts the federal funds rate to stimulate financial activity. A decrease in interest rates by the Federal Reserve has the opposite effect of a rate hike. Investors and economists alike view lower interest rates as catalysts for growth—a benefit to personal and corporate borrowing. This, in turn, leads to greater profits and a robust economy.
Consumers will spend more, with the lower interest rates making them feel that, perhaps, they can finally afford to buy that new house or send their kids to a private school.

Interest Rates and 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 key indexes many people equate with the market—the Dow Jones Industrial Average, S&P 500, etc.—will go down. With a lowered expectation in the growth and future cash flows of a company, investors will not get as much growth from stock price appreciation.

Interest Rates and the Bond Market

Interest rates also impact bond prices and the return on certificate of deposits , Treasury bonds, and Treasury bills. There is an inverse relationship between bond prices and interest rates: as interest rates rise, bond prices fall . The longer the maturity of the bond, the more it fluctuates in accordance to changes in the interest rate.
When the Federal Reserve raises the federal funds rate, newly offered government securities,–such as Treasury bills and bonds–are often viewed as the safest investments. They will usually experience a corresponding increase in interest rates. In other words, the risk-free rate of return goes up, making these investments more desirable. As the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same , investors may feel stocks have become too risky and will put their money elsewhere.
The measure of the sensitivity of a bond's price to a change in interest rates is called the duration.
One way governments and businesses raise money is through the sale of bonds. As interest rates move up, the cost of borrowing becomes more expensive.

Impact of Expectations

Nothing has to actually happen to consumers or companies for the stock market to react to interest-rate changes. Rising or falling interest rates can also impact the psychology of investors psychology. When the Federal Reserve announces a hike, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop, and the market may tumble in anticipation. On the other hand, when the Federal Reserve announces a cut, the assumption is consumers and businesses will increase spending and investment. This can cause stock prices to rise.
If expectations differ significantly from the Federal Reserve's actions, these generalized, conventional reactions may not apply. For example, suppose that the Federal Reserve is expected to cut interest rates by 50 basis points at its next meeting, but they instead announce a drop of only 25 basis points. The news may actually cause stocks to decline because the assumption of a cut of 50 basis points had already been priced into the market.
The number of points the Dow dropped on Oct.

The Bottom Line

Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions—as a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down.