Explainer · Markets & Macro
How interest rates affect markets
When a central bank changes its policy rate, the effect spreads from overnight bank lending to bonds, shares and exchange rates. The direction is often predictable in theory. The size and timing are not.
Quick answer
Higher interest rates make existing fixed-rate bonds worth less, tend to make shares less attractive and can draw money into the currency. Lower rates tend to do the opposite. The effects arrive with long, variable and uncertain lags, so they are hard to predict [3].
Key points
- In the US, the Federal Reserve steers the federal funds rate, the rate banks pay to borrow reserves overnight [1].
- When market rates rise, prices of existing fixed-rate bonds fall; longer bonds fall more [4].
- Rate changes tend to move stock prices and exchange rates, but the source uses "tend to", not "always" [1].
- A 1-point rise cut our 9-year example bond from $1,000 to $925.04, a 7.5% fall (calculated).
- Trading rate announcements with leverage magnifies both gains and losses [7].
On this page
What does a central bank actually change?#
A central bank does not set every interest rate in the economy. It sets one short-term rate and lets the rest of the system react. In the US, the Federal Open Market Committee (FOMC) targets the federal funds rate, which is the interest rate banks pay to borrow reserve balances overnight [1]. It influences that rate by changing the interest the Fed pays on reserves banks keep at the Fed [1].
The FOMC has twelve members and holds eight regularly scheduled meetings a year [2]. Its legal goals are maximum employment, stable prices and moderate long-term interest rates [1]. For the bigger picture of what these institutions do, read what does a central bank do.
The European Central Bank describes the same first step: a change in its official rates directly affects money-market rates and, indirectly, the lending and deposit rates banks offer their customers [3].
Each arrow in that chain is described by the Fed or the ECB [1] [3]. What the sources do not give is a timetable: the ECB says the transmission is characterised by long, variable and uncertain time lags [3].
Why do bond prices fall when interest rates rise?#
A fixed-rate bond pays the same coupon until it matures. If new bonds start paying more, nobody will pay full price for an old bond that pays less, so its price drops until its return matches the market. The SEC puts it simply: market interest rates and bond prices generally move in opposite directions, and this is called interest rate risk [4].
The SEC's worked example uses a $1,000 bond with a 3% coupon paid twice a year and 10 years to maturity, bought when market rates are also 3%. One year later, with 9 years left, market rates have risen to 4% and the bond's price has fallen to $925. If rates had fallen to 2% instead, the price would have risen to $1,082 [4]. We reproduced both figures with standard present-value arithmetic: $925.04 and $1,081.99 (calculated).
The SEC also states that the longer a bond's maturity, the greater the risk that its value is hit by changing rates before maturity [4]. The table applies the same 1-point rise and fall to the same 3% bond with different amounts of time left, so you can see that effect in numbers.
| Time left to maturity | Price if rates rise to 4% | Change | Price if rates fall to 2% | Change |
|---|---|---|---|---|
| 2 years left | $980.96 | -1.90% | $1,019.51 | +1.95% |
| 9 years left (SEC example) | $925.04 | -7.50% | $1,081.99 | +8.20% |
| 29 years left | $829.27 | -17.07% | $1,219.24 | +21.92% |
Same price changes for a $1,000 bond with a 3% coupon paid twice a year, starting at $1,000 when market rates are 3%. All prices calculated by present value; the 9-year row matches the SEC example [4]. Assumes the issuer keeps paying.
How do interest rates affect stock prices?#
The Fed's explanation is that changes in interest rates tend to affect stock prices by changing how attractive shares are compared with other investments [1]. When safer assets such as bonds or deposits pay more, the case for taking on stock market risk has to be stronger. When they pay less, shares can look relatively more appealing.
Rates also work through the real economy. Higher rates make borrowing for consumption or investment less attractive [3], while lower consumer loan rates encourage more spending on goods and services [1]. The ECB adds a wealth effect: as share prices rise, households that own shares become wealthier and may spend more [3].
How do interest rates affect currencies?#
Money moves across borders looking for returns. The Fed notes that changes in US interest rates alter how attractive US assets are, which will move exchange rates and the dollar's value [1]. The Reserve Bank of Australia lists changes in interest rate differentials, meaning the gap between two countries' rates, among the things that drive an exchange rate over the medium term [5].
The chain also runs back the other way. The ECB explains that exchange-rate changes can affect inflation directly through the price of imported goods [3]. We cover the other drivers in what moves exchange rates.
How quickly do markets react to a rate change?#
Some effects are fast. The Fed says a change in the federal funds rate is rapidly reflected in the rates lenders charge on short-term loans [1]. Others are slow: effects on spending, jobs and prices arrive with lags that the ECB calls long, variable and uncertain, which makes the precise effect hard to predict [3].
Long-term rates depend partly on what markets expect short-term rates to do in future [3]. So a change in expectations, for example after a new inflation report, can move long-term rates even in a month with no rate decision. That is one reason beginners who wait for the decision itself are often surprised by what has already moved. Our guide what is CPI explains the inflation numbers central banks watch.
How can a beginner follow rate decisions safely?#
You do not need to forecast rates to be affected by them. What helps is knowing when decisions happen and what you hold that is sensitive to them. Our economic calendar guide shows how to find the dates.
- Put the meeting dates in your diary
The Fed publishes FOMC meeting dates in advance; the remaining 2026 meetings are October 27-28 and December 8-9 [6]. Other central banks publish their own calendars.
- List what you own that is rate-sensitive
Fixed-rate bonds and bond funds (longer maturities move more), shares, foreign currency and anything bought with borrowed money.
- Check your borrowing costs
Short-term and floating-rate loans reprice quickly when the policy rate changes [1]. If you borrow to invest, your costs move with them.
- Decide your plan before the announcement
If you would not be comfortable with a large move in either direction, reduce the position beforehand rather than reacting in the moment.
- Read the statement, not just the headline
The minutes, published three weeks later, give more detail on the reasoning [6].
Mistakes beginners make with interest rates#
- Assuming bonds are always safe
A fixed-rate bond's price falls when market rates rise. In the SEC example a 1-point rise took a $1,000 bond to $925 [4].
- Treating "rates up, stocks down" as a law
The Fed says rate changes tend to affect stock prices; it gives no fixed size or guarantee of direction [1].
- Expecting instant results in the economy
Effects on spending and inflation arrive with long, variable and uncertain lags [3].
- Mixing up CPI and the Fed's target
The Fed's 2% goal is measured with the PCE price index, not the CPI [1].
- Trading the announcement with high leverage
Leverage amplifies both gains and losses, and losses can exceed the initial deposit [7].
Frequently asked questions#
Why do bond prices go down when interest rates go up?
Because new bonds pay the higher rate, an existing bond with a lower fixed coupon is only worth buying at a lower price. The SEC calls this interest rate risk [4].
Do higher interest rates always make stocks fall?
No. The Fed says rate changes tend to affect stock prices by changing how attractive shares are compared with other assets [1]. Other news arriving at the same time can outweigh it.
Why does a currency often rise when its interest rates rise?
The bottom line#
Interest rates are the price of money, so a change at the central bank ripples into almost every market. Bond prices move the opposite way to rates, longer bonds most of all; shares and currencies tend to react, but with no fixed rule; and the economy responds slowly. Know the meeting dates, know what you hold that is rate-sensitive, and size any position so a surprise is survivable. Read the risk disclosure before trading anything with leverage.
Sources
- Monetary Policy: What Are Its Goals? How Does It Work?.
- Federal Open Market Committee.
- Transmission mechanism of monetary policy.
- Investor Bulletin: Fixed Income Investments - When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall.
- Exchange Rates and their Measurement.
- Meeting calendars and information.
- Customer Advisory: Eight Things You Should Know Before Trading Forex.
Education only. This page is not investment, tax or legal advice. Trading and crypto can lose you money. See our risk disclosure.
