We often hear news about the Federal Reserve raising interest rates, the Bank of England raising interest rates, the People's Bank of China lowering interest rates; central banks around the world are making significant moves. What is the logic behind these operations, and how do interest rates affect the economy? Let's discuss this today.

1. Why are interest rates so important?

When a central bank detects a poor economic condition, it begins to lower interest rates. As interest rates decrease, the interest on bank deposits also diminishes. Capital markets are highly sensitive and profit-driven. When the interest earned from bank deposits is minimal, other investment products become relatively more attractive. Capital gradually flows out of banks and into products with higher investment returns or is used for consumption, such as buying homes, cars, handbags, investing in stocks and funds, or opening restaurants, etc. In summary, this leads to a reduction in savings and an increase in investment and consumption.

At the same time, the lending rates of banks will also decrease. Everyone rushes to borrow money, with companies taking loans to expand construction and investment in production, and individuals borrowing to buy homes and cars. The entire chain of investment, production, and consumption becomes more active. Money borrowed from banks flows into the market, akin to injecting fresh capital into a swimming pool, driving the recovery of the entire economy.

As industries expand, the economy improves, and the amount of money in the market increases. The income of the public and businesses rises, as does their consumption capacity and demand. However, supply may not keep up in the short term, leading to rising prices for goods, which eventually leads to inflation. This is a natural phenomenon when the economy is in an expansion phase.

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If there is too much money in the market, causing inflation to rise too quickly, the central bank will hit the brakes and may even start raising interest rates. With higher bank deposit rates, many funds begin to slowly flow from the stock market, bond market, funds, and real estate back to banks.

At the same time, lending rates also gradually increase. The repayment pressure on businesses and individuals grows, leading to fewer people borrowing and those who have borrowed reducing their spending and accelerating repayment. As a result, money gradually flows back to banks, and thus, interest rate hikes have the effect of withdrawing funds from the market.

Subsequently, with less liquid capital in the market, purchasing power declines, supply outstrips demand, and prices fall, eventually leading to deflation and a downward economic trend. Then, banks start adjusting interest rates again to lower them and release more money, which is the relationship between the economic cycle and the rise and fall of interest rates. It is also what we often hear about the interest rate hike cycle and the interest rate cut cycle.

2. What is the relationship between interest rates and the stock market, and how does an interest rate hike affect the stock market?

(1) From the company's perspectiveWhen interest rates rise, the cost of borrowing or issuing bonds for listed companies increases, leading to higher financing costs for these companies. This can hinder their development, thus creating a bearish sentiment for the stock market.

Raising interest rates has a relatively greater impact on industries that rely heavily on financing. If a company has a significant portion of its balance sheet in debt, especially short-term debt, the impact of interest rate hikes can be quite substantial.

However, interest rate hikes can be beneficial for certain industries, such as banking and insurance. After all, banks profit from the spread between lending and borrowing rates.

(2) Consumer Perspective

After an interest rate hike, the rates on mortgages, auto loans, and credit card loans increase, leading to greater repayment pressure. This can cause people to reduce their consumption, which in turn lowers overall demand. As a result, it becomes more difficult for companies to make profits, creating a bearish sentiment for listed companies from the consumer's point of view.

Industries that are particularly dependent on loans are more significantly affected, such as the housing and automotive sectors. People often need loans to purchase these items, so the impact on these companies is greater. The impact on general consumer goods is relatively smaller, as it's not common for people to take out loans to buy everyday items like toilet paper.

(3) Valuation Perspective

Warren Buffett once said that interest rates affect stock valuations like gravity. When interest rates are low, stock valuations tend to be high. When interest rates rise, this gravitational pull can bring stock valuations down significantly.

For a company, once interest rates increase, the discount rate also rises. This means that future cash flows are worth less when discounted back to the present, especially for growth companies whose profits are expected in the future, thus reducing their present value.

So, from a valuation standpoint, rising interest rates are also bearish for the stock market.(4) From the perspective of capital flows

When the central bank raises interest rates, the overall market liquidity tightens, and short-term stock investors find themselves with less cash on hand, which is also bearish for the stock market. This is the most direct impact.

What has been mentioned above only represents the influence on the stock market to a certain extent, but the reality is far from being so simple.

For instance, as mentioned earlier, interest rate hikes typically occur during periods of inflation. However, during inflation, many people choose to buy houses as a hedge against inflation. From this perspective, it is a positive for the real estate market, creating a contradiction.

Therefore, the economy is a very complex entity, with everything influencing each other in a complex and intertwined manner.

When the central bank announces an intention to raise interest rates, it is usually bearish for the stock market because stock trading is sometimes about trading expectations. After a while, the impact becomes almost negligible.

3. Finally

After the 2008 financial crisis, the world entered a channel of declining interest rates. Major global economies adopted low-interest rates to push money out of banks. Japan and the Eurozone even implemented negative interest rates, which means that not only do you not earn interest on money deposited in banks, but you also have to pay the bank a storage fee. Although our interest rates have not dropped to zero, the interest has long been unable to keep up with the pace of inflation.

In order to save the economy after the financial crisis, the United States took the lead in implementing quantitative easing, which, in simple terms, is about injecting money into the market by purchasing government bonds. After several rounds of quantitative easing, a continuous flood of printed money has been poured into the global pool, constantly driving up the prices of assets.

It's not just the United States; the whole world is printing money frantically, and the debt leverage crisis is also growing larger.Now, the United States is again using interest rate hikes and quantitative tightening to suck back the money that has been printed over the years. The speed of this pump is getting faster and faster, and the pressure on asset bubbles is increasing. In the end, everyone who is swimming naked in the market will be exposed one by one.