In the past month, the Dow Jones Industrial Average had seen a spectacular fall. The market had crashed more than a thousand points. This crash happened on the speculation that the Federal Reserve i.e. the central bank of America is planning to raise interest rates. The mere mention of the possibility of an interest rate hike caused the market to have a panic attack. This obviously raises the question about why is it that markets are affected so drastically by decisions made by the central banks. In this article, we will have a closer look at the relation between the stock market and the central bank.

The Changing Nature of Valuation

Graham Dodd is considered to be the father of stock valuation. In 1934, he wrote a book explaining how the modern theory of valuation has departed from the traditional principles. He believes that the old approach was more dependent upon the past performance. This means that the dividends that the firm has paid in the past, the absence of any debt and the strong track record of the management were considered major factors in stock valuation.

However, this has changed now since the entire theory has become more future-oriented. This means that a firm’s value is now based on the amount of cash flow it can provide in the future. This means that even a firm has not paid a single penny in dividend till date, its valuation can be justified by saying the value will be received in the future.

However, the basic theory of finance says that a dollar today is more valuable than a dollar tomorrow. Hence, the future cash flow dollars of a company need to be discounted at the present rate to arrive at a valuation. The discount rate being used therefore has a huge bearing on the final stock value. Since the discount rate is derived from the interest rate, interest rates become extremely crucial. It is for this reason that central banks decision to hike or lower the rates can have a massive impact on the stock market. It is for this reason that it can be said that 2018 will have a general negative trend. The Fed is planning about four consecutive interest rate hikes and this may lead to some form of a correction in the stock market.

How Exactly Do Interest Rates Affect Stocks?

There are two reasons why changes in the interest rates affect the valuation of stocks:

1. Firstly, lower interest rates encourage firms to borrow money. Lower interest rates mean that the firm has access to cheaper credit. This means that interest will form a smaller share of their total expenses. The amount of interest saved will be simply added to the profit. Hence, lower interest rates create a temporary speculative boom.

2. Secondly, the interest rate is a major factor in the discount rate that is used to calculate the value of the firm. Hence, a lower interest rate would mean a lower discount rate. This would lead to temporary bloating of the value of the firm.

In simpler words, a lower interest rate creates a false image making a firm look more profitable than it actually is.

What Happens When Interest Rates Rise Again?

The increase in the interest rates leads to a precipitous fall in the stock market. This is mainly because of the following reasons:

• Lower interest rates led to malinvestment. This means that the projects that were selected because credit was so cheaply available end up subtracting from the value of the firm instead of adding to it. The end result is that the scarce resources are squandered away.

• Firms know that their production will not be as profitable when interest rates are increased. This is because they will have to pay a larger share of their income as interest. As a result, when interest rates hikes are announced, companies try to cut production. They try to sell off their assets and pay back loans which have suddenly become unsustainable.

• The high valuation of the stocks which was being justified by the possible gains that will be received in the future suddenly crashes. This is because the future dollar becomes more expensive. This changes the time preference of the investors, and they try to cash in today instead of waiting for the future.

In short, the entire economy is misled by the central banks when they drop interest rates. For a short while, they create an artificial boom which is followed by an even larger bust. The problem with this is that people do not want to suffer the consequences and start afresh. As a result, they ask central banks to lower the rates even further. This creates another temporary boom which negates the losses made from the earlier bust. However, this boom is also temporary at best and is likely to lead to another bust. Hence, it is the low-interest rates set by the central bank that creates business cycles. This is exactly what happens after every bust. For instance, consider the government policies of zero interest rate after the 2008 subprime crisis.