Rising Rates by Joe Stenovec, MS, CFP®
I don’t really know why the financial markets are surprised by rising interest rates, but as usual the market is correcting based on these new conditions. When the financial markets realized in March of last year that COVID-19 was going to impact the economy, interest rates dropped to new lows with the 10-year treasury hitting about a half of a percent by August. That means you could lend the US Government a dollar for 10 years and expect to earn a half of one percent each year for 10 years! Not much return, although a risk-free investment, so we think.
Today that same treasury is just over 1.5%. That’s a dramatic increase, but coming from an extreme low. Why is this relevant? What is it telling us?
Interest rates rise because investors expect economic growth to increase in the future and therefore inflation to rise. This lowers the incentive to own treasuries. But wouldn’t an acceleration of economic growth be good for the stock market? Why is this creating volatility?
The market has been expecting interest rates to stay low for a long time but with more fiscal stimulus coming, that creates more dollars, pushing the dollar’s value down causing the price of goods to rise. This cycle creates pressure on that 10-year treasury. Yes Joe but you said rising interest rates/inflation mean the economy is doing well! Well…not so fast. There are two sides of the coin when it comes to inflation. There’s the expected increases in wages/earnings for workers and there’s increases in production and manufacturing costs that cause the price of goods and services to rise. The former is good, the latter is bad. Unless they are happening together.
If the cost of goods are going up but wages are not, that means consumers have less money to spend because more dollars have to go into the purchase of [you name it]. Not good. Not good for the consumer, not good for the economy. This happened back in the 70’s.
This dynamic is having a negative impact on the stock market, in particular technology stocks. When someone places a valuation on a stock, that “risk free rate” I have talked about in the past becomes a key input. That’s the 10-year treasury. The lower the rate, the higher price someone may be willing to pay for a stock. The lower the rate, the higher the price, and vice versa. The “market” expected rates to stay lower, but with these changes in expectations comes a correction in the math, and therefore the markets.
With low interest rates, technology stocks in particular are prone to volatility. There are a lot of reasons for that, but a main one is the fact that borrowing costs for companies that are not profitable is expected to increase, which can create a negative feedback loop. Here’s a chart of the last three months looking at Nasdaq in Orange(ish) with the 10-year in purple. You can see there was a point where tech finally started to take notice of rising rates.
I don’t know how much the market will correct due to these changes in circumstances but ultimately what is happening is expectations are changing. With evolving expectations comes changes in prices. In this case, higher expected interest rates due to inflation creates less incentive to pay a really high price to own certain types of companies. Hence the most expensive segments of the market are dropping.
Oftentimes the market over-shoots expectations. In this case, maybe interest rates don’t rise as much as “the market” thinks they will, therefore the selloff in technology stocks gets overblown. Or maybe a rise in inflation is so short-lived because it was primarily caused be stimulus, which is temporary. Who knows, only time will tell.
This is why it is so important to not get too over extended in one area of the market vs another. You own technology stocks in your portfolio, but also banks and other companies that have really nothing to do with tech. We will stay diversified not only across stocks or bonds, but also across sectors of the vast global economy.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.