How Does the Fed “Prop Up” the Stock Market? (Interest Rates and Stock Prices)

A reader writes in, asking:

“I’ve read over and over this year that the Fed is ‘propping up’ the stock market by keeping interest rates low. How does that work?”

Broadly, there are two ways in which low interest rates help to keep stock prices high.

Firstly, to the extent that corporations are borrowers, keeping interest rates low reduces their costs and therefore directly improves their profitability, which of course helps keep their share prices higher. In the case of a struggling corporation, having access to low-cost capital can even make the difference between declaring bankruptcy or not. And of course avoiding bankruptcy proceedings is good for shareholders.

The second effect has to do with the way stocks are priced. (I think it’s actually easier to understand this effect from the perspective of increases in interest rates. So we’ll start with that.)

Stocks are quite a bit riskier than Treasury bonds. So why do you own stocks at all, rather than just buying Treasury bonds with all of your savings? Presumably, you own stocks because you hope to earn additional returns beyond what Treasury bonds earn. That additional return that you hope to earn is known as a risk premium (i.e., additional return to compensate you for the additional risk).

The price of a stock reflects the (market’s consensus as to the) present value of the future cash flows from the stock. And the discount rate used in that present value calculation is usually something along the lines of “whatever we could earn from bonds, plus a risk premium.”

So when interest rates go up, the necessary discount rate goes up. A higher discount rate means a lower present value, which means stock prices go down.

Or you can think of it this way: imagine that TIPS yields suddenly went way up to 3%, rather than the roughly -1% range where they are right now. Maybe you had been estimating that stocks would earn a 4% real return going forward. Before, that was a 5% risk premium. But with TIPS yielding 3%, a 4% real return would only be a 1% risk premium. Maybe you decide that a 1% expected risk premium isn’t high enough to justify the additional risk from owning stocks, so you sell your stocks to buy TIPS.

Collectively, lots of people would be selling stocks to buy bonds in such a scenario. So the price of stocks would fall. When the price falls, the expected return going forward goes up (because a new buyer is paying a lower price for a given amount of dividends/earnings). And the price would continue to fall (i.e., people would keep selling stocks) until the price was low enough that the expected return was high enough to earn whatever the market collectively decided was a sufficient risk premium over bonds.

So that’s what happens when interest rates go up: it has a downward effect on stock prices.

When governments or central banks make efforts to keep interest rates low, the opposite occurs: it exerts an upward pressure on stock prices. That is, low interest rates make the alternatives to stocks not look very appealing — and that helps keep stock prices high.

To be clear though, while low interest rates have an upward effect on stock prices (i.e., they make stock prices higher than they would otherwise be, all else being equal), they do not prevent stock prices from falling. When events occur that worsen the outlook for corporate profitability, stock prices will still fall.