How do interest rate changes affect stock markets?

Interest-rate changes reshape stock markets primarily by altering discount rates, borrowing costs, and expectations about future growth. When central banks raise policy rates, the yield on safer assets such as government bonds typically rises; higher yields reduce the present value of future corporate cash flows, which lowers equity valuations. Conversely, lower policy rates reduce discount rates and often push investors toward equities in search of higher returns. Janet Yellen of the Federal Reserve Board has emphasized that monetary policy affects asset prices through both direct financial channels and by changing economic outlooks.

Transmission channels

The most immediate channel is valuation: many equity models, including those discussed by John Y. Campbell of Harvard University and Robert J. Shiller of Yale University, link stock prices to expected future dividends and the discount rate used to value them. A higher interest rate increases that discount rate and tends to compress price-to-earnings ratios, especially for firms whose earnings are expected further in the future. A second channel is cost of capital: higher interest rates raise borrowing costs for households and firms, reducing consumer spending and corporate investment and thereby slowing earnings growth. A third channel is portfolio reallocation: rising yields on bonds can pull capital out of stocks into fixed-income securities, increasing equity risk premia and volatility.

Expectations and surprises matter as much as the rate level. Research on monetary policy surprises shows that markets react strongly to unexpected rate changes or to new information about policy direction. Ben S. Bernanke of Princeton University has written about how central bank communication and credibility shape market responses. If a tightening is perceived as a response to overheating, markets may interpret it as stabilizing and react less negatively than if a hike signals persistent weakness in growth prospects.

Sectoral and global consequences

Different sectors respond unevenly. Financial institutions often benefit from steeper yield curves because they can borrow short and lend long, while high-growth technology and consumer discretionary firms with valuations tied to distant profits are more sensitive to rate increases. Real estate and utilities, which carry substantial leverage and offer bond-like cash flows, typically underperform when rates climb.

Territorial and cultural factors influence the net effect. Countries with large pension fund holdings of equities or with high household indebtedness experience stronger wealth and consumption feedbacks when rates move. Emerging markets can suffer capital outflows and currency depreciation during global rate increases, amplifying domestic financial stress. Low-rate environments have been linked to rising wealth inequality because asset owners receive disproportionate gains; international institutions such as the International Monetary Fund have noted distributional concerns in prolonged low-rate regimes.

Policy implications and risks are clear: central banks aiming to stabilize inflation must weigh the trade-offs between slowing asset-price inflation and avoiding abrupt market disruptions. Transparent communication and gradualism can reduce unnecessary volatility, while macroprudential measures can limit credit-driven asset bubbles that low rates can encourage.