Rising Interest Rates; More Than What Meets the Eye
February 22, 2021
By Tom Limoges
Asst. VP - Investments
Some things in life seem great at first glance, but end up much more complicated once we dig into understanding them. Eating healthy sounds wonderful until that cauliflower rice doesn’t quite hit the spot. Being a first-time homeowner is thrilling until you have to mow your lawn in 100 degree temperatures, or snow blow your driveway in -25* windchill. Life is often bittersweet. Along with the highs come the complications, hesitations, unexpected detours, and second thoughts. Like life, investing is filled with these bittersweet paradoxes.
Under the Surface
After falling sharply in 2020, bond yields have been on the rise recently due to improving economic fundamentals and rising inflation expectations. For bond investors, the jump in rates can be bitter-sweet. Rising rates can signal higher coupon payments (income) from new bond purchases. However, this can negatively impact the values of existing bonds owned in a portfolio as yields and bond prices move in opposite directions. In addition to the impact to the bond market, stock prices can also be affected by an increase in rates.
Source: Federal Reserve Bank of St. Louis
The Impact of Rising Rates
Rising interest rates can impact the stock market several ways. First, higher interest rates can impact what banks charge their customers to borrow money. Rising interest costs for loans, credit cards, and mortgages can affect the amount of money consumers are willing to spend. Consumer spending makes up a significant portion of our economy. If the consumer is spending less on goods and services, generally this is a negative for the companies in the stock market. In the same way, business spending can also be impacted by increased borrowing costs.
Second, financial analysts compare valuations of the stock market to historical averages to determine if the current market is cheap or expensive when compared to historical averages. Market valuations over short-term time periods can be unpredictable in their way to predict future market returns. However, over the longer term, that relationship has a higher degree of correlation. Valuations are a widely used measure in estimating longer-term market returns. Higher market valuations are generally associated with lower (not necessarily negative) longer term returns in the future.
Source: JP Morgan Guide to the Markets
In the example chart above, the market remains at higher levels compared to the 25-year average. The last measure compares the earnings yield of the market to the yield of bonds. Low interest rates make the stock market more attractive as an investment when compared to bonds. If rates were to unexpectedly jump, investors may consider the stock market less attractive compared to the bond market and money could flow from stocks to bonds – potentially affecting stock prices. With the last point, it is important to remember that stock market valuations should never be considered a timing device, as they can remain at extreme levels of valuation (highs and lows) for much longer than expected.
Bond yields are on the rise, which created some uncertainty in the markets in the past week. Rising yields are not always a negative for stocks as they are also a sign of an improving economy, which is good for the stock market. It is important to monitor how high and how quickly yields can rise. Interest rates, while still low compared to historic averages, remain competitive with long term inflation prospects. The Federal Reserve remains committed to keeping rates at lower levels for the foreseeable future – keeping financial conditions loose and the economic recovery on track.
The complexities of life are often what gives it its flavor. The ups and downs keep us on our toes, and the harmony of the shifting highs and lows help us to appreciate the moment. It’s always important to dig deeper into something that may seem easy and good on the surface. Just like rising interest rates, there are weaknesses that come alongside the apparent strengths - and it’s important to have perspective and patience- and be an informed investor. If you have any questions on the information discussed here or how it affects your portfolio, please call us. We are here to help you achieve your goals.