How Interest Rate Changes Affect Australian Shares

Interest rates are one of the most powerful forces which move share prices but why does their impact vary dramatically from one company to another?

Interest rates are among the most powerful forces that affect the stock market because they influence almost everything that determines a company's value like consumer spending along with borrowing costs and the price investors are willing to pay for future earnings. When the Reserve Bank of Australia raises or cuts the cash rate, the effects gradually pass through mortgages, business loans, savings accounts and financial markets. This effect will create winners and losers across different ASX sectors as the relationship is not as simple as saying rate cuts are always good for shares while rate rises are always bad.

Why interest rates have such a powerful effect on share prices?

The first reason interest rates matter is that they directly affect the cost of money across the economy. Higher rates make mortgages along with personal loans and corporate borrowing more expensive while lower rates generally make credit cheaper. Australian households with variable-rate mortgages can have their monthly repayments increase significantly which leaves less disposable income for other discretionary purchases. 

Interest rates also directly affect companies because businesses often borrow money to fund acquisitions, construct new facilities, buy equipment or expand operations and higher borrowing costs can reduce profits and make new investments less attractive. Highly leveraged companies are usually more vulnerable because even a modest rise in interest expenses can reduce the earnings available to shareholders and businesses with strong balance sheets and large cash reserves are generally better positioned.

Which ASX shares benefit or suffer when rates rise?

Banks are among the most closely watched beneficiaries of higher interest rates because their profits come from the difference between the interest earned on loans and the interest paid to depositors. This difference is known as the net interest margin and during the early stages of a rate-hiking cycle, banks may benefit if lending rates rise faster than deposit costs. This can expand margins but excessively high rates can eventually become harmful because financially stressed households and businesses may struggle to repay loans. 

Insurance companies can also benefit from higher rates as they invest large pools of premium income before claims are paid which will allow them to earn better returns on fixed-income investments when yields rise.

REITS are often particularly sensitive to higher interest rates because property businesses tend to carry substantial debt and compete with bonds. If government bonds start to offer attractive yields then investors will demand higher dividend yields from property stocks. This can put downward pressure on valuations while higher borrowing costs can also squeeze profits. 

A company's share price theoretically represents the present value of the cash it is expected to generate in the future. When interest rates rise, those distant future earnings become less valuable in today's money. This is why high-growth technology companies can be particularly sensitive to higher rates. Much of their expected value may come from profits anticipated many years into the future which means a higher discount rate can cause valuations to fall even when the underlying business does well.

What happens to ASX shares when interest rates fall?

Interest-rate cuts generally support economic activity because they reduce borrowing costs, improve household cash flow and encourage businesses to invest but the reason behind a rate cut is extremely important. If the RBA cuts rates because inflation is under control while the economy is reasonably healthy, share prices can do well because lower financing costs and stronger spending may support earnings. The outcome can be very different if rates are cut rapidly because unemployment is surging or the economy is entering a deep recession. 

Growth stocks are often among the strongest potential beneficiaries of falling rates because lower discount rates increase the present value of their future earnings. Technology companies with strong growth prospects can therefore receive a double benefit. Lower borrowing costs may support economic activity while investors can simultaneously become willing to pay higher valuation multiples for future profits.

REITs and other income-oriented shares can also become more attractive because declining bond yields encourage investors to look elsewhere for passive income. Consumer discretionary businesses may benefit substantially when lower mortgage repayments leave households with more disposable income.