Why does the stock market rally when there is an interest rate cut?

On 1 October 2019, the Reserve Bank of Australia (RBA) decided to cut the cash rate to 0.75%. This is the lowest in Australian history. On the day of the news, the share market rallied. This has often happened on the back of interest rate cuts. If the RBA is cutting rates because of problems with the economy, then why does the share market rally? Why is it a positive for stocks?

Borrowing cost of companies

When interest rates are cut, it lowers the cost of funding for businesses. Companies often need to borrow funds to expand their businesses. This means that a rate cut can increase their profits because of the decrease in interest expenses. Investors will see this as positive for shares and buy into the sentiment that companies will now increase profits. Property trust and utilities in particular are interest rate sensitive. This is because they are highly leveraged to lower interest rates.

Increase of household income

Similarly, to the businesses, households will see a decrease in interest payment obligations on their loans when there is a cut in the official interest rates. Provided that banks pass on the cut, households will have more disposable income to spend.

Increase of investment in share markets

With the decrease in interest rates, households may find that they will have an increase of funds in the household budget. This could encourage people to invest surplus funds into the share market.

Increase in consumer spending

With the increase on household budgets, consumers will have increased capacity to spend on goods and services. This would increase the demand on products and generate more earnings for companies. This may translate into higher share prices.

Decreased demand for bonds

There may be a rotation out of bonds and into the share market if interest rates decrease. Bond investors may be reluctant to buy bonds when rates are cut to an all-time low. This is because their bonds will decrease in value when interests are hiked back up again.

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Moving out of bank deposits

A decrease in interest rates may cause banks to decrease their interest rates on term deposits and bank accounts. Investors wanting to earn more yield on their funds may decide to move out of bank deposits and into dividend yielding stocks. These may generate a 6% yield as opposed to 1% on a bank deposit.

Decrease of the Australian dollar

The news of the interest rate cut caused the Australian dollar to fall to $0.67 US cents. This is the lowest in 10 years. Companies on the stock market which export good to other countries, such as resources, will benefit from a decrease in the Australian dollar. This is because it keeps their products more competitive. Companies which also generate substantial earnings overseas can also benefit from the drop in the Australian dollar.

Lauren Hua is a private client adviser at Fairmont Equities.

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