In school, you learn there is an inverse relationship between interest rates and bond prices. When rates go higher, bonds go lower and vice versa. It is a pretty easy concept to understand: assuming all other things being equal, would you pay the same amount for a security paying 3% as you would one paying 5%? Unless you are unique, probably not.
Interest rates are nothing more than the cost of money in a financial system or economy. The higher the interest rate, the more expensive it is to borrow in absolute terms. If you remember supply/demand curves from Econ 101, the demand for just about anything will go DOWN as the price goes UP. The inverse is also true.
So, here is the progression: when rates go up, money becomes more expensive. This curbs the demand for borrowing, which slows the growth of the money supply in the economy. Intuitively, this should/could/would slow overall economic activity. Slower growth will typically lead to lower corporate profits, in general. Obviously, this isn’t good for stock prices, let alone real estate (due to a decline in demand for mortgages, etc.).
Others might add higher interest rates reflect expectations for inflation in the future. The higher the current rate of interest, the greater the potential for inflation. This reduces the present value of future cash flows from an investment, as you have to discount them at the higher rate. It also means borrowing costs are higher for corporate borrowers, which will ‘eat into’ profits and drive down stock prices.
Regardless of the approach, the prevailing wisdom is: higher interest rates are typically an obstacle to higher asset prices, in general. That is until they aren’t, like this week…at least for stocks.
As I type here at 12:13 pm CST on 11/8/2019, the yield to maturity (interest rate) on the 2.25% 30-year US Treasury Bond due to mature in August 2049 is 2.41%, and is trading a price of $96.5703125. Last Friday, it closed at $101.296875, to yield 2.41%. That is an INCREASE of 22 basis points (.22%) in rate and a DECREASE in price of, get this, 4.67%.
While not unprecedented, that is a pretty sharp move in rates in one week. Ordinarily, this would send shivers down the spines of ALL investors, not just ones buying bonds. This week, it didn’t, as evidenced by an almost 20-point increase in the S&P 500 from last Friday’s close, as of 11:58 am CST on 11/8/2019. For grins, that works out to be an annualized (annual equivalent) return of roughly 38.91%. I am not a psychiatrist, but it would appear stock investors either like or don’t care the rate interest.
Which is it? Despite my previous contention higher rates eat into corporate profits, I would argue investors like it. The reason is kind of mental gymnastics.
As you probably know, and I am making an assumption since you are reading an economic newsletter, the US Treasury ‘yield curve’ has/had inverted at several points, famously between 2-year securities and 10-years. Further, the overnight lending target rate (where the Fed says banks should lend overnight to one another) had been higher than the yield on the 10-Year US Treasury Note for months. This is important, as banks borrow from depositors mostly on a short-terms basis (think a checking or money market account) and lend longer-term to borrowers. When this spread, the difference between where banks borrow and where they lend, contracts, banks tend to make fewer loans, in general, and far fewer speculative loans. This slows the creation of money in the system, and the proverbial death spiral begins.
Yes, this week’s missive is nerdier than normal. But Wait! There is more!
At the end of September, the official overnight rate was 2.00%. By comparison, the 10-Year Note had a yield to maturity of 1.67%. Obviously, that is a difference of -33 basis points, which isn’t a good omen for future economic growth. At the end of October, this spread had narrowed to -6%, as the Fed cut the overnight rate 25 basis points during the month and the 10-Year ticked up slightly. While better than it was the month previous, the curve was still inverted (at least by this measure), and that isn’t a good thing.
This week, the yield on the 10-Year has shot up 24 basis points this first week of November 2019. Since the target overnight rate hasn’t changed, the spread has gone from that -0.06% to +0.18%. In essence, the yield curve has gone from inverted (here and elsewhere) to positively sloped in a short period of time. Historically, and I have to write ‘past performance is not indicative of future results,’ bad things tend to NOT happen when the curve is positively sloped.
So, in Frankenstein talk: “Before week…yield curve…inverted. End of week…yield curve…not inverted. Good.”
So good, in fact, this might be one of the few weeks in my career when longer-term rates spike close to 0.25% AND the stock markets like it. After all, higher rates are generally bad news for all kinds of investments; that is, until they aren’t. About the only time they aren’t is when they take the yield curve from inverted to positively sloped.
…and that wraps up this past week pretty tightly in slightly less than 900 words.
Have a great weekend.