interest rates and the stock market

The iron law of microeconomics, as the business school professor I learned micro theory from used to revel in saying, is: what determines price is the availability of substitutes. As regular readers may not, I like writing this as well.

Its relevance for me in today’s stock market world–it raises the question of at what yield do Treasuries become a reasonable enough substitute for stocks that investors begin to change their portfolios by selling stocks to buy bonds.

The yield on 10-year Treasuries is 1.96%. On the 30-year, it’s 2.25%. The dividend yield on the S&P 500 is now about 1.35%. Taking the 10-year, I would probably pick up 60bp in yield over the next year by switching money from an S&P index fund into bonds.

On the other hand, the long-term yearly return from holding stocks is something like 300-400bp higher than from holding bonds. And the Fed is closer to the beginning than the end of the process of raising interest rates back up from their emergency pandemic lows. While this is going on, the price of already-issued bonds is more likely to fall than rise.

Nevertheless, even though today is probably not the time to do so, I think it’s an important question. At what yield would stock market investors like you and me begin to allocate money away from stocks and into bonds?

I’ve only rarely held bonds, so I’m not going to be in the vanguard of the movement. Still, if the10-year were to yield, say, 4%, I’d have no qualms about switching some of my less favorite stocks into bonds.

What about at 3%? For me, no. Maybe I’d look at the 30-year, though, to see if there would be enough yield pickup to influence my decision.

Why is this important to think about?

Rising interest rates can influence stocks in two ways:

–higher rates means higher interest expense for companies with large amounts of bank debt …which means earnings lower than they otherwise would be. I haven’t looked at any depth, and there must be some companies that would be negatively affected this way, but there’s been such immense issuance of corporate debt at lower interest rates that I can’t imagine that higher interest expense is an existential issue for the S&P. And, conceptually at least, this possible negative should me more than offset by gains in the value of corporate long-term debt issued over the past few years.

–at some point, rates can reach a high enough level that new money goes into bonds instead of stocks, and maybe old money leaves stocks for fixed income. I think this potential effect is the much greater threat to today’s stock values than simply rising rates.

more tomorrow

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