Deep Dive: How Interest Rates Affect the Stock Market — From Fed Policy to Your Portfolio

The most direct channel through which interest rates affect stock prices is the discount rate used in valuation models. When investors value a company, they discount its expected future cash flows back to the present using a rate that reflects the time value of money and risk. The risk-free rate — typically proxied by Treasury yields — forms the foundation of this discount rate.

When the Fed lowers its benchmark rate, Treasury yields tend to follow (though not always in lockstep). A lower discount rate mathematically increases the present value of future earnings, making stocks appear more attractive at any given price. This is particularly powerful for growth companies whose value is concentrated in distant future cash flows. A company expected to generate significant earnings five or ten years from now sees a much larger valuation boost from falling rates than a mature business with most of its value in near-term cash flows.

The 10-year Treasury yield, currently at 4.08% as of mid-February 2026, serves as a key benchmark for equity valuations. When this yield was closer to 4.29% in early February, the implied fair value for stocks was lower. The roughly 20-basis-point decline in long-term yields over the past few weeks has provided a modest tailwind for equity valuations, contributing to the S&P 500's resilience near all-time highs.

Beyond valuations, interest rates directly affect corporate profitability. Companies routinely borrow to fund operations, expand capacity, make acquisitions, and buy back shares. When interest rates rise, the cost of servicing existing variable-rate debt increases and new borrowing becomes more expensive, squeezing profit margins. Conversely, when rates fall, companies can refinance at lower rates and access cheaper capital for growth.

This effect varies dramatically by sector. Capital-intensive industries like utilities, real estate, and telecommunications carry substantial debt loads and are highly sensitive to rate changes. A 100-basis-point increase in borrowing costs can meaningfully erode earnings for a utility company carrying billions in long-term debt. On the other hand, technology companies that generate abundant free cash flow and carry minimal debt may be relatively insulated from higher borrowing costs — though their valuations still respond to the discount rate effect described above.

The current environment illustrates this dynamic well. With the Fed Funds rate at 3.64% and the 30-year mortgage rate at 6.01%, borrowing costs remain elevated by historical standards despite the recent easing. Companies that locked in low-rate debt during 2020-2021 face a wall of maturities in coming years, making the pace of future rate cuts critically important for corporate balance sheets.

One of the most important — and most misunderstood — aspects of the rate-stock relationship is that markets are forward-looking. Stock prices don't wait for the Fed to announce a rate decision; they move in advance based on expectations about what the Fed will do.

This is why stocks sometimes fall on the day the Fed cuts rates, confusing casual observers. If the market had already priced in a 50-basis-point cut and the Fed delivers only 25 basis points, that's effectively a tightening relative to expectations. The September 2025 rate cut from 4.33% to 4.22% — the first in the current easing cycle — was widely anticipated, and much of its positive impact on equity valuations was already reflected in stock prices before the announcement.

The yield curve provides a real-time gauge of rate expectations. The current spread of 0.60% between 10-year and 2-year Treasuries (positive after years of inversion) signals that the bond market expects the current easing cycle to continue, but at a measured pace. A steepening yield curve generally supports equities because it suggests improving economic growth expectations and ample room for further monetary easing.

For investors, the implication is clear: what matters for stock prices is not the current level of interest rates, but how actual Fed policy compares to market expectations. Surprises — in either direction — are what move markets most dramatically.

Interest rates cannot be analyzed in isolation from inflation. What ultimately matters for both the economy and stock valuations is the real interest rate — the nominal rate minus inflation. With CPI running at approximately 2.2% year-over-year (the January 2026 CPI index at 326.6 versus 319.7 a year earlier) and the Fed Funds rate at 3.64%, the real short-term rate is roughly 1.4%. This positive real rate means monetary policy, while easing, remains restrictive relative to inflation.

For stock investors, the real rate matters because it determines the true opportunity cost of holding equities versus risk-free bonds. When real rates are deeply negative (as they were in 2020-2021), there is no alternative to stocks for investors seeking real returns — the famous TINA trade. When real rates are meaningfully positive, as they are today, bonds become a genuine competitor for investment capital.

The Fed's ability to continue cutting rates depends heavily on the inflation trajectory. If inflation remains near 2.2% and continues trending toward the Fed's 2% target, further cuts are likely. But if inflation re-accelerates — perhaps driven by tariff policies or supply-side disruptions — the Fed may be forced to pause or even reverse course. Such a scenario would be decidedly negative for equities, as it would combine higher discount rates with slowing economic growth.