Could Rising Interest Rates Hurt Stocks?
During the last week of May, the rate on the 10-year Treasury bond rose to 2.15 percent, the highest since April 2012. Since bonds are priced off of the Treasury spot rate curve (both in discounting the present value of the bonds’ future cash flows and in the spread relative to the spot rate curve ), it was not surprising that the value of the majority of bonds dropped at the same time. However, the stock market also gave back some of its double-digit gains for the year.
- Why do investors think that higher interest rates are bad for stocks? First, similar to bonds investors attempt to identify the true value of a stock by finding the discounted value of future cash flows. If future cash flows are discounted at a higher interest rate, then the present value of those cash flows – and thus the stock’s current intrinsic value – is lower. Second, higher interest rates could hurt the economy over the short term by encouraging less lending and spending and more saving. This is the reason the Fed has continued to purchase Treasuries and mortgage bonds: the Fed doesn’t want rates to rise and risk hurting the economic recovery.
- Although the historical correlation between long-term Treasury bonds and stocks is close to 0 (i.e. there is no linear relationship between the two), the correlation between the two has fluctuated significantly in the past. For example, as interest rates steadily declined over the past three decades (since interest rates and bond prices move inversely to each other, bond prices rose), both bonds and stocks performed well. As a result, there was a positive correlation between the two during this long time period.
- However, during the recent recession, there was a negative correlation between stocks and bonds. This resulted from the risk-on-risk-off trading mentality of investors. If news (economic, monetary, etc.) was considered positive, stocks increased while Treasuries sold off. If news was considered negative, stocks declined while Treasuries were bid up. Furthermore, a Deutsche Bank report found that since 2000 rising bond yields (and thus falling bond prices) have been associated with rising stock markets: U.S. equity returns were positive in 71 percent of months with rising bond yields.
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Kruger, Daniel. Treasury 10-Year Yield Highest Since April 2012 on Confidence. 28 May 2013. Bloomberg. 3 June 2013.
Spot Rate Curve: a yield curve constructed using Treasury spot rates rather than yield.
Discounted Value of future cash flows: time value of money
Ro, Sam. No, Surging Interest Rates Are Not a Disaster for Stocks. 2013 June 3. Business Insider. 3 June 2013.
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