Capital Markets Undergo Notable Repricing in Response to Rising Inflation and Higher Interest Rates | U.S. Bank (2024)

Key takeaways

  • U.S. capital markets are following up a strong 2023 with a solid start to 2024.

  • Capital markets, such as the equity and fixed income markets, match those who have capital to invest with businesses, government entities and entrepreneurs seeking capital to underwrite their plans.

  • Investors appear encouraged by current economic signals as they assess capital market prospects for 2024.

Capital markets enjoyed a solid rebound in 2023 following a difficult year in 2022, when both equity and fixed income markets suffered significant declines. Equity markets were particularly strong in 2023, with the benchmark S&P 500 index gaining more than 26%, primarily on the strength of strong performance from technology companies. Bond markets overcame a challenging environment to generate modestly positive returns.

“The macroeconomic backdrop for 2024 is one of slowing growth,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “At the same time, inflation has slowed considerably from peak levels reached in mid-2022, though cost-of-living changes remain somewhat elevated compared to what we became accustomed to in recent decades.” Haworth believes the current environment offers potential for both equity and fixed income investors.

Current capital market drivers

While surging inflation and rising interest rates were driving forces in the market’s challenging 2022, the market’s recovery that began in 2023 was supported by declining inflation and surprisingly solid economic growth. In today’s environment, Haworth sees three primary factors at work:

  • Slowing growth and falling inflation. Haworth says it appears likely that the pace of U.S. economic growth could slow in 2024, though the current U.S. Bank forecast is that a recession is avoided. Inflation, which declined significantly in 2023, is expected to further decline in the months to come. However, inflation in recent months has stabilized in the low 3% range.
  • Improved corporate earnings. Earnings, or a company’s profits, are typically one of the biggest drivers of capital market performance. “We’re in the second quarter of an earnings recovery,” says Haworth, “in contrast to an earnings contraction that was underway in the first half of 2023.” Haworth says that provides support to the markets, as earnings growth helps lay the groundwork for rising stock prices.
  • Changes to Federal Reserve (Fed) interest rate policy. The Fed raised rates 11 times between March 2022 and July 2023 in an effort to slow economic growth and quell the inflation threat. “Fed rate hikes weren’t unlike being on a treadmill where the incline is being increased,” says Haworth. “It made the environment more challenging for companies and investors.” The Fed has indicated that rate hikes are likely done for the current cycle. “That could help the economy continue to expand and help stocks continue to do well,” says Haworth.

    Haworth says the environment may also become more productive for fixed income investors. “Interest rates are near their highest levels in 14 years,” says Haworth. “If the Fed begins to lower the federal funds rate it controls sometime in 2024, that should help bring bond yields down across the broader market, which would boost returns for bond investors.” In the meantime, investors can earn much higher yields from bonds than they have for more than a decade.

The current capital market environment remains constructive given the ongoing strength of the economy, but investors need to be prepared for periods of market volatility. Ultimately, factors like corporate earnings and the direction of interest rates will have the greatest impact on equity and fixed income markets. However, the potential exists for other events to temporarily impact the markets and potentially contribute to investor uncertainty. Read more about our capital market perspective in our quarterly investment outlook.

Capital markets explained

Here are answers to some fundamental questions that may help you better understand capital markets and how they work.

What are capital markets?

Capital markets are a way to bring together individuals or institutions with money (also known as capital) they wish to invest, and various entities that seek money to underwrite costs to meet specific purposes. Capital markets also facilitate the issuance of securities on an exchange, where stocks and bonds are offered by those seeking capital, to be purchased by investors seeking to put capital to work.

For example, government entities regularly issue debt securities (bonds) to meet costs for major capital projects or, in the case of the federal government, finance day-to-day expenditures. Investors, in effect, lend money to the government entity by purchasing a bond. The borrower is required to pay interest on a timely basis and repay principal when the bond matures.

What are types of capital markets?

Capital markets are most commonly made up of stock and bond markets.

  • Stock (equities) is issued by a corporation, providing an ownership stake in the firm. Individuals and institutions can purchase stock in the firm, obtain voting rights as a shareholder, and be a recipient of dividends paid out by the corporation from its earnings (profits). Stock values can rise and fall, and investors can re-sell shares through an exchange on the secondary market, which is where bonds or shares of stock are bought and sold after their initial public offering.
  • A variety of entities issue bonds, such as governments, school districts and corporations. By purchasing a bond, the investor becomes a lender and is due interest and principal payments. Bondholders always take priority over stockholders when it comes to repayment, should the entity that issued the security face financial difficulty, such as bankruptcy.

How do capital markets work?

A key to capital markets is the issuance of securities. Entities seeking to raise capital issue debt or equity securities that are exchanged with investors. A corporation, for example, may issue new shares of stock, at a set price. However, once on the open market, the price of a security is generally always changing, reflecting demand in the market.

When raising capital, companies or entities may issue new shares of a stock or bonds, with proceeds from investors going directly to the issuer to meet its current financial purposes. Original issues of stocks and bonds are not always accessible to individual investors, such as in an initial public offering (IPO) of stock. Most individuals purchase stocks on the secondary market, where those who previously purchased stocks or bonds can re-sell the securities they hold.

How do capital markets differ from financial markets?

There are similarities between the two; however, capital markets typically refer to the issuance of new securities to raise capital, while financial markets can refer to all forms of securities trading.

Financial markets encompass a wide variety of exchanges involving traditional securities like stocks and bonds, as well as other types of assets and contracts. Most individuals trade securities on the secondary market.

Talk to your financial professional

As you assess your own financial goals, understanding the current and anticipated performance of capital markets may help you more effectively position your assets to achieve your objectives. Discuss your circumstances with your financial professional to help determine the best steps to consider in today’s capital markets.

Our investment strategies are designed to weather all types of market cycles. Learn about our investment management approach.

Capital Markets Undergo Notable Repricing in Response to Rising Inflation and Higher Interest Rates | U.S. Bank (2024)

FAQs

What happens to the stock market when the Fed raises interest rates? ›

As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as to how the market will react to any given interest rate change.

How do interest rates affect capital markets? ›

Higher interest rates tend to negatively affect earnings and stock prices (often with the exception of the financial sector). Changes in the interest rate tend to impact the stock market quickly but often have a lagged effect on other key economic sectors such as mortgages and auto loans.

Will bank stocks go up when interest rates drop? ›

The lower interest rates signaled by the Fed this week will decrease the cost of borrowing for banks to fund loans and other transactions, KBW banking analyst Chris McGratty noted. This has helped trigger a surge in bank stocks that extended for a second day on Thursday following the Fed's latest meeting.

How does rising interest rates affect banks? ›

As interest rates rise, profitability on loans increases, as there is a greater spread between the federal funds rate that the bank earns on its short-term loans and the interest rate that it pays to its customers. In fact, long-term rates tend to rise faster than short-term rates.

Do banks make more money when interest rates rise? ›

Do banks make money when interest rates go up? Yes, they do make more money when interest rates are higher, but not in the way you might think. Their profits don't go up simply because you are paying a higher amount of interest as a result of a rate increase.

What stocks do well when interest rates rise? ›

Financials First. The financial sector has historically been among the most sensitive to changes in interest rates. With profit margins that actually expand as rates climb, entities like banks, insurance companies, brokerage firms, and money managers generally benefit from higher interest rates.

Who benefits from high interest rates? ›

As interest rates rise, the interest income from loans typically increases faster than the interest paid on deposits, leading to wider profit margins. Additionally, higher interest rates can boost the earnings of insurance companies and investment firms, as they often hold large portfolios of interest-sensitive assets.

Should you sell bonds when interest rates rise? ›

If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond's price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates.

Are interest rates determined in the capital market? ›

The interest rate is determined in the loanable funds market, and the quantity of capital demanded varies with the interest rate. Thus, events in the loanable funds market and the demand for capital are interrelated.

Do banks make money in a recession? ›

When economic activity slows down, bank stocks are typically among those hit hardest. That's because banks' earnings are, to varying extents, tied to borrowers' ability to repay their loans, as well as to consumers' and businesses' appetite for more credit.

What is the best bank stock? ›

  • Citigroup Inc. (C)
  • Bank of Montreal (BMO)
  • PNC Financial Services Group Inc. (PNC)
  • Fifth Third Bancorp (FITB)
  • M&T Bank Corp. (MTB)
  • Regions Financial Corp. (RF)
  • Citizens Financial Group Inc. (CFG)
  • East West Bancorp Inc. (EWBC)
Mar 12, 2024

Are bank stocks a good buy during inflation? ›

Bank stocks increase in value during periods of inflation, which makes them appealing to investors. Higher net interest margins: Banks earn money from the difference between the interest rates they charge on loans and the interest rates they pay on deposits.

Who makes money when interest rates rise? ›

Banks make money from the interest they charge on loans. As interest rates rise, banks can often charge a higher interest rate on loans and credit cards compared with the rates they have to pay savings and other interest bearing accounts.

Why do banks raise interest rates when inflation is high? ›

Raising rates may help slow spending by increasing the cost of borrowing, potentially reducing economic activity to slow inflation down. Raising rates may also encourage saving, as money in a savings or CD account earns more interest than in a low rate environment.

What is repricing in banking? ›

In the banking sector, repricing opportunities are periods when interest-rate sensitive assets and liabilities are up for adjustment. Banks earn income from interest, so their income fluctuates with changes in interest rates.

What makes the stock market go up and down? ›

By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

Why do rising interest rates generally depress stock prices? ›

Why do rising interest rates generally depress stock prices? Businesses have to pay higher interest rates to borrow money, thus reducing their profit. Stock investors tend to take their money out of the stock market & invest in interest paying investments. Future earnings will not be worth as much as today.

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