Interest rates, central banks, and economic data
The policy rate is one of the most important numbers for financial markets, because many investments have to measure up to it. Economic data mainly matter through what they mean for future interest rates.
Learning objective: After this lesson you can judge why the policy rate and economic data move financial markets.
When safe interest rates rise, risky investments become less appealing by comparison. Why take on the risk of stocks if a savings account pays you a safe four percent? That's why rising rates usually weigh on share prices. In 2022 central banks raised rates quickly, and stocks and bonds fell sharply at the same time.
When rates fall
The same applies the other way round. When rates fall, risk becomes more appealing and prices often rise. That's an important relationship to remember.
Economic data as a detour
Economic data such as inflation, the labour market or growth usually work in a roundabout way. They change what investors expect the central bank to do next. That's why good news about the economy can make prices fall if it makes higher rates more likely.
What this means for you
As a long term investor you don't need to do anything about it. But it helps to understand why markets twitch on certain days instead of thinking it's inexplicable.
The policy rate works in several ways. First, it's the rate investors use to convert future profits to today. If it rises, future profits are worth less today, and that hits companies whose profits lie far in the future hardest, such as young tech firms. Second, it changes what companies pay for loans and so their profits. Third, it makes bonds more or less attractive compared with stocks.
Why surprises matter
How the market reacts depends on whether the decision is a surprise. What investors expect from central banks can be read from futures markets. An expected rate hike therefore barely moves prices. A surprising sentence at the press conference afterwards, on the other hand, can trigger big moves.
Economic data in context
How economic data work depends on the situation. If the central bank is mainly fighting inflation, good economic data push prices down, because they suggest tighter monetary policy. If everyone is worried about growth, the same data support prices. So the same news can have exactly opposite effects depending on the environment. Forecasts based on single figures are therefore almost worthless.
Summary
- Rising safe interest rates usually weigh on risky investments.
- What counts is how much a decision surprises, not the decision itself.
- The same economic news has opposite effects depending on the situation.
Did you get it?
In what ways does the policy rate work?
Through the rate used to convert future profits, through companies' borrowing costs and through how attractive bonds are by comparison.
Why does an expected rate hike barely move markets?
Because it's already in the price. Moves come when something differs from expectations.
Why can good economic news push prices down?
If it makes tighter monetary policy and higher rates more likely.
Check your understanding
Your task
Imagine the central bank raises the policy rate by one percentage point. Write three sentences on the ways this affects stocks and bonds. Then find an economic news item from the past week and note whether it is more likely to raise or lower interest rate expectations.
Sources and further reading
- The Federal Reserve Bank of Atlanta derives market-implied probabilities for future interest rate decisions from interest rate futures on an ongoing basis. View source ↗
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