It is hard to fully appreciate the historic nature of the current interest rate environment in the U.S. and the rest of the developed world. For much of the past year since the onset of COVID-19, the prevailing rate of interest on saving and borrowing has fallen to a low never seen in the history of our republic. Over the past two weeks, however, pressure has been building and investors are obsessing over the potential risks posed by higher interest rates, causing stock prices to gyrate in response to news or rumors from the bond market. Forget Robinhood. The latest shiny object is the 10-year Treasury bond.
The relationship between interest rates and stock prices is complicated. On the one hand, a growing economy is usually accompanied by increasing incomes, higher prices, and rising rates. To a point, this is normal and healthy, and since it implies higher sales and bigger profits, stock prices tend to appreciate in accord with economic growth.
On the other hand, the general level of interest rates is a critical input to estimating the fair value of a stock. Conceptually, the value of a company’s stock is estimated by “discounting” all future cash flows like dividends. The more interest rates rise, the bigger the discount, causing the fair value of a stock to fall, all else equal. If nothing else changes, higher rates are bad for stocks.
Of course, all else is never equal, and these two competing forces are in constant tension. Typically, when the economy emerges from a recession, stock prices are undervalued and slowly recover in response to growing sales and profits despite the usual concomitant rise in inflation and interest rates. But the current scenario is a historical outlier in that the broad stock market recovered its pandemic losses so dramatically and returned to a historically overvalued level even though the recovery is far from complete. The fatter the valuation, the more susceptible stock prices become to upward rate pressure.
It is also useful to note that the extraordinarily low level of interest rates for the past several years have been at least in part due to aggressive actions taken by central banks like the U.S. Federal Reserve System. Central banks cannot pass stimulus bills or run budget deficits; these remedies are the purview of legislatures. But the Fed and its counterparts have taken unprecedented actions since the aftermath of the 2008 recession to stuff interest rates into the basement and hold them there, hoping to encourage additional borrowing intended to promote job creation and income growth.