The second lesson of two on interest rates, why they are so important to the stock market and to traders and investors in the stock, futures, and forex markets with an introduction to the Federal Reserve.
In yesterday's lesson we began our discussion on Monetary Policy with a look at one of its primary components, interest rates. In today's lesson we are going to continue this discussion with another look at how interest rates affect the economy and therefore the markets, and by introducing the institution which implements Monetary Policy, the Federal Reserve.
As we saw in our example yesterday, small movements in interest rates can have dramatic effects on the economy. Just as small changes in interest rates can dramatically increase the costs for individuals to own a home or borrow money to purchase other goods, they can also have a dramatic affect on the cost of doing business.
It is for this reason that when interest rates rise, making borrowed money more costly, that people will also be less likely to start or expand a business. This not only has an effect on the business owner themselves but filters throughout the entire economy as less businesses being started and expanded means less jobs, which means less people getting paychecks, which means less people spending money and on and on down the line. The opposite is of course also true for when interest rates fall and business owners take advantage of access to cheaper borrowed money.
In addition to interest rates affecting the stock market, interest rates also have direct and indirect affects on the bond, foreign exchange, and futures markets. Here are a couple of quick examples of this which we will expand on in later lessons:
The Bond Market: When interest rates rise the value of existing bonds fall as investors can now purchase the same bond with a higher interest rate and vice versa.
The Forex Market: When Interest rates it becomes more attractive from a yield standpoint to own the dollar against other currencies or to invest in interest bearing dollar based assets. This creates a demand for dollars which will many times cause the dollar to strengthen. The reverse is also true when interest rates fall.
The Commodities Market: When economies grow at a greater rate as a result of lower interest rates this will mean a greater demand for commodities so their value will rise and vice versa.