upward pressure on rates = downward pressure on prices
As I’m writing this, the 10-year Treasury note yields 1.52%. This means that if I were to buy a freshly-issued one right now, I’d exchange my $1000 for twice-yearly payments of $7.51 each and the return of my $1000 ten years from today.
Suppose it’s tomorrow, Tuesday, and interest rates have risen overnight to the point where a brand-new 10-year Treasury yields 3%–meaning $1000 buys two payments of $15 each year plus the return of principal after ten. If I want to sell my one-day-old Treasury in tomorrow’s market, it will certainly be worth less than what I paid. I have almost no idea what the right figure is …$960? But my point is that rising rates push down the price of existing fixed-income instruments.
Because stocks are competitors/substitutes for bonds as liquid investments, rising rates push down the price of stocks as well.
Arguably, also, when money is more or less free, people are more cavalier in their attitude toward risk. When the returns on a money market fund or a bank deposit rise, and especially if they reach a point where those returns become significant (whatever that might mean), investors tend to pull in their horns a bit–creating a further contraction in stock values.
This suggests that as interest rates rise, the overall price earnings ratio for the stock market begins to contract, as well as that stock market investors begin to adopt a more conservative stock selection style.
the Fed intends to raise rates this year
We know this because the agency said it would last November, for one thing.
For another, interest rates have been at emergency lows, and negative in real (subtracting inflation) terms, for an extended period. After too much of this, and especially after the worst of the emergency is over, the economic system can begin a journey down the road of unravelling that ends in the country becoming another Brazil or Turkey. Not good.
Also, short-term interest rates are effectively at zero now, since the annual rate of interest the government pays for one-month loans is 0.06%. In theory, nominal rates could turn negative, as has happened in the EU. But I don’t think Washington has any appetite for this. My impression is that the weirdness of negative rates has offset any possible benefit. And real rates are strongly negative–meaning interest rate policy is highly stimulative–as things are now. In other words, as a practical matter there’s only one way rates can go, and that’s up.
when? how high? what’s the effect on earnings growth and PEs?
These are the important questions for the stock market.
more tomorrow