Global markets posted a big rally after the United States Federal Reserve announced that it would not be raising interest rates last week. The Fed did state, however, that one more rate hike was likely this year. With many investors expecting a September rate hike, the news was welcomed, and caused markets to surge the following day.

But why? So often investors react to news and events, but don’t really understand the underlying causes and reasons that markets are behaving the way they are. That’s why we’re going to take a moment to explain why the Fed interest rates are so important.

Central banks have an ability to influence general interest rates through their Federal funds rate. This is the rate at which institutions loan money to one another on an overnight basis. This rate also has a major influence on all other interest rates, such as car loans, mortgages, personal loans, and business loans.

This means that if the Fed raises interest rates, interest rates for various loans will go up. This, in turn, will cause the economy to cool. Let’s dig into why.

High interest rates curb consumption and investing

High interest rates can slow down economic growth. This is one of the primary reasons that investors tend to fear high interest rates. Of course, fear among investors can result in sinking markets.

So why do high interest rates curb economic growth? For one, it becomes more expensive for companies and individuals to take out loans. This means companies will slow their investments in new business operations, staff, equipment, etc. Further, home purchases and other major purchases also often slow.

This reduction in both consumer spending, and business investment, can have a very big impact on the economy, and thus financial markets.

Higher interest rates are also more enticing for investors

High interest rates are also attractive for investors, especially when it comes to bonds and other assets. That’s good right? In many ways yes, bonds can be great, safe investments and are excellent for wealth management.

Yet, there’s only so much money to go around. Thus, when bonds look enticing and investors start pouring money into bonds, there’s less money to invest in stocks. In fact, high interest rates can encourage people to liquidate some of their stock holdings so money can be redirected to invest in bonds.

This can cause stock markets and other asset markets to drop. Add in the fear of dropping markets, and sell-offs can quickly emerge.

Why the Fed announcement caused markets to surge

So, the Fed announced that it would not raise rates this month, but also that a rate hike is still likely this year. Markets surged in response. In Japan, the Nikkei 225 closed up nearly 2%, and most other Asian markets surged by a half percent or more. In Europe, the DAX and CAC 40 both surged by over 2%, while the FTSE 100 gained 1.12%. On Wall Street, markets also trended up.

Why? Part of it obviously comes down to the fact that the Fed prolonged an action that could curb economic growth. Digging deeper, however, it’s important to understand that markets had expected a rate hike, and adjusted to it. When the rate hike was prolonged, markets had to readjust.

Understanding how markets adjust and readjust to expectations is essential for investors.