The Cost of Funds

The interest rate represents the price of borrowing funds. It is the cost that borrowers have to pay to use money; the higher the price, the less likely borrowers are to borrow. It is also the reward that lenders receive for letting someone borrow their money; investors compare this return with the expected return in other markets, such as the stock market, when they decide where to allocate their funds.

Short-Term Interest Rates

The theory behind using short-term interest rates as stock market signals is based on two assumptions. First, interest-bearing investments are alternatives to stock investments. In other words, savers make choices about placing their investment funds in interest-bearing securities or the stock market. When interest rates are relatively high, the interest-bearing securities look relatively more enticing. Second, interest rates directly affect costs for corporations and, thus, corporate earnings. However, the interest rate itself is important because the expected rate of return in the stock market must be greater than the short-term interest rate for investors to invest. When interest rates begin to rise, while the stock market languishes, investment outlooks begin to change. On the corporate and personal level, rising rates translate into rising costs. Whether it is working capital borrowing or adjustable rate mortgage payments, increases in short-term rates have a negative effect on net income and, by extension, on confidence. Alternatively, when rates decline, costs also decline and confidence builds. Furthermore, and regardless of potential reasons, short-term interest rates correlate very closely but inversely with stock market behavior. To know when a major switch in direction in short-term interest rates has occurred is important knowledge as to a probable switch in stock market direction.