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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.

This is the standard tool kit when rates are normalized and the economy needs a boost. But the world since 2008 is not the world of 1981; inflation has been non-existent and the globe is awash in savings, so the central banks' rate maneuvers have been relatively ineffective at stimulating capital investment and consumption. Instead, most of the juice has gone into inflating asset values like stock prices and real estate. We have no historical precedent for this particular set of conditions.

This is hardly lost on investors. While the outlook for a post-pandemic economic surge is hopeful, excesses exist in certain sectors that could prove quite sensitive to meaningful increases in interest rates. This has been manifested in recent volatility as stocks rise and fall sharply with moves in the Treasury market. Furthermore, given the lack of alternatives for retirees and others seeking income, money has flowed out of bonds into stocks in search of better returns despite the additional risk. As rates start to increase, stocks could become less attractive to risk-averse investors seeking income.

The yield on the U.S. 10-year Treasury bond is only now recovering back its level of one year ago, so it is still a bit early to wring our hands. In a December speech, Fed Chairman Jay Powell acknowledged that stock prices were high, but that extraordinarily low rates made those excess valuations "less relevant." Still, interest rates do matter at some point, and with the recent moves in the 10-year yield, stock investors are keeping a close eye on the bond market.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.

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Contributed photo / Christopher Hopkins

 

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