Finance, Forex and Investments

What is the relationship between interest rates, bonds, and stock prices?

I always am hearing people talk about how important the interest rates that the government sets are. The have some sort of effect on stock prices and bond prices. What is that relationship is and WHY?

Public Comments

1. As interest rates go up bond prices go down and as interest rates go down bond prices go up. Usually, when bonds go up stocks go down and vice versa but not always.
2. Best answer I can give you. Interest Rates are set by the Federal Reserve, those are rates charged to the banks for money. Bond Rates are an open market, the Federal Reserve doesnt control them (those would be mortgages, or bond to sell for the price of war). Its open pricing. They say we need 10 billion dollars what will you pay for it? its bidded on. Person that is willing to pay the least for a contract on the bond market gets it. Its something like 95% of the money we used to finance Iraq came from china in the bond market. The mortgage bonds and Treasure Bonds compete. Mortgage rates go up because they have to compete against the Government. They bid against eachother. http://finance.yahoo.com/ (good place to watch what is going on in the market) Stock Rates are also open market people pick what they want to pay. The reason that when the feds change interest rates or give a bad accounting companies think crap the cost of us doing business will be more expensive. They also will see a drop in sales at car dealearships etc. It scares the market. They are all connected but not directly. They are all connected but not directly. Sometimes when the fed raises the interest rate, the bond market gets a lower rate. Because that is supply and demand. More companies want the Bond Market then the Stock Market ect. To make it simple Feds only control the Banks. Everything else is open market. They bid for what the price is every day. It goes up and down. I know this is clear as Fog but thats the best I can tell you. It would take me a year to explain this question. Thats the best I can give you. ******* UPDATE ******** Good steward gave a great answer, I gave him a thumbs up. Thats assuming you knew what he was talking about in the first place. His answer was like teaching Algebra to a 5 year old. But he was dead on.
3. Let me try to answer this with some examples. Bond prices goes up when interest rates goes down, and bond prices goes down when interest rates goes up. Here's an example why: Let's say you have a bond that is worth $1000 and pays 5% coupon interest. You then decide to sell that bond when interest rates increased. You will now have to sell that bond for less than $1000. Since interest rates increased, investors can now get a bond that is worth $1000 and pays 6%. So in order to make your bond appealing to investors you will have to lower the price of your bond so that they can make up for the difference in interest that your bond is paying. (Remember your bond is paying 5% and they can easily get one that pays 6%) Here is an example of how it works the other way: Let's say you are still holding the same 5% bond and interest rates dropped to 4%. If you decide to sell your bond now you can charge more for it because the investors can only find bonds paying 4% while you have one for sale offering 5%. The investors will be willing to pay more for that bond to have the higher coupon rate. The relationship between stocks and interest rates are a little more complicated because it has more variables but the relationship is usually inverse as well. If interest rates rise stock prices tend to fall. Interest rates drop stock prices increase. There are many variable as to why this can occur. When interest rates are low it is cheap for companies to borrow money. They can now use the funds to expand their business, refinance higher interest debt... and so on causing the stock price to increase. When rates are high it is more expensive for them to expand their business therefore making the stock prices drop. Another reason why stock prices have an inverse relationship to interest rates is because most money managers use the interest rate as one of the variable in calculating the intrinsic value of the stock. So if interest rates change the intrinsic value of the stock changes with it. The examples I gave above are very general and simplified. You also have to keep in mind that there are other variables at play. For example there is the credit rating of the bond, maturity, coupon rate... and the list can go on. I hope that made it easier to understand.