Interest rates: the gravity on prices

A central bank nudges its key interest rate up by half a point. It does nothing to any company’s factory, staff, or products. Yet within minutes, share prices across the whole market slide. A bakery in one country and a software firm in another — businesses with nothing in common — both drop at once. No customer changed their mind. So what just happened?

A number changed. And that number sits underneath the price of almost everything.

Interest rates pull on every asset

Think of the interest rate as gravity. You can’t see it, it touches nothing directly, but it tugs on every asset’s price at the same time. Raise the rate and the tug gets stronger; prices feel heavier and sink. Lower it and the tug eases; prices float up.

Why should one number have this reach? Two plain reasons, and they’re really the same idea seen from two sides. The first is about the alternative on offer. The second is about what future money is worth today. Take them one at a time.

Reason one: the safe alternative gets better

You already know (from item 3) that investors demand more reward to hold a risky thing than a safe one. A share might pay off big or disappoint; a safe government savings account just pays its interest, come what may.

Now suppose that safe account starts paying 5% a year instead of 1%. Suddenly the boring option is decent. Why take the worry of owning a business for a so-so return when cash pays 5% for free? Investors won’t. They’ll only hold the risky share if it promises more than 5% — say, the same risk premium on top of a higher floor.

But here’s the catch: the business itself hasn’t changed. It will earn the same profits next year whether rates are 1% or 5%. The only way to squeeze a bigger return out of the same future profits is to pay a lower price for them today. So buyers offer less. The price falls until the cheaper entry point gives them the return they now demand. The safe alternative rose, so the risky asset had to get cheaper to compete.

Reason two: future money shrinks

The second reason is the deeper one. A pound in your hand today is worth more than a pound arriving in five years — because today’s pound can sit in that 5% account and grow. So a future pound has to be discounted: marked down to what it’s worth to you now. The higher the rate, the harder you mark it down.

Here is the move in one line: to find a future pound’s worth today, shrink it by the rate, once for each year you must wait.

A stock’s fair price is just the sum of all the profits it will ever hand you — each one shrunk back to today. Raise the rate and you shrink every future profit harder. So the price, which is the sum of those shrunk profits, falls.

A worked example: three years of profit

Picture a small business that will pay you £100 a year for three years, then stop. What’s that stream worth to you today?

Discount it at a low rate of 2%. Each year’s £100 is shrunk by 2% per year of waiting:

• Year 1: £100 ÷ 1.02 = £98
• Year 2: £100 ÷ 1.02 ÷ 1.02 = £96
• Year 3: £100 shrunk three years over = £94
• Fair price today ≈ £288

Now discount the same £100-a-year at a high rate of 10%:

• Year 1: £100 ÷ 1.10 = £91
• Year 2: £100 ÷ 1.10 twice = £83
• Year 3: £100 ÷ 1.10 three times = £75
• Fair price today ≈ £249

The business didn’t change. The £100 cheques didn’t change. Only the rate moved — and the fair price fell from £288 to £249. Raise the rate, the future is worth less now, the price drops. That’s the gravity, in numbers.

The far future falls hardest

Look again at the high-rate column. Year 1 lost £9, but year 3 lost £25 — more than twice as much. The further away a pound is, the more years of shrinking it suffers, so it falls hardest when the rate rises.

This is why a rate rise hits some shares harder than others. A steady business that pays you mostly soon barely flinches. But a fast-growing firm — one whose big profits are years out, the kind of company priced on what it’ll earn a decade from now — gets hammered. Most of its value sits in the far future, exactly where the discount bites deepest. (This builds on item 8’s valuation: the more of a price that rests on distant earnings, the more rate-sensitive it is.)

The whole, not the headline

A rate decision is a single hand on a single dial, made in one room. Yet it reaches every asset at once — bonds (item 2), shares here, the house someone’s deciding to buy, the savings everyone is parking somewhere. None of it is independent of that one number. The strategist who studies a company in perfect detail and forgets the rate is reading half the page.

That’s worth holding loosely. When prices fall together for no company-specific reason, gravity usually changed, not the businesses. You can’t argue with gravity, and you can’t fully escape its pull — it’s tugging on whatever you own too. Knowing it’s there, and which way it’s leaning, is most of what there is to know.