Bond yields rise, investors sweat: Why interest rates matter

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As of January 2018, the size of the U.S. bond market (as measured by debt outstanding) was nearly $41 trillion, compared with about a $30 trillion value for the U.S. stock market– and that’s after stocks had a massive run in 2017.

The importance of the bond market
It may seem counterintuitive, investors worried about a stock market crash should be watching the market for U.S. Treasury bonds. How bonds move– that is, investors’ expectations for the future trajectory of interest rates– is perhaps the best indicator of how the stock market as a whole will move.

While the stock market gets all the headlines, the bond market– where you can sell or buy debt from companies, others and governments– is much larger and arguably more important to the economy.

The true effect of hitting 3% is more psychological than scientific. Rather than letting the headlines make you fearful, this milestone is a great chance to refresh your grasp of how the bond market affects the stock market and what you can learn from rising interest rates.

Here’s why you should watch interest rates– but also not get swept up and scared that rising rates will destroy your portfolio.

As for importance, while the stock market measures the value of America’s publicly traded companies (no small thing), the bond market shows how much interest investors are willing to accept for tying up their capital for a period of time. In other words, the bond market measures the cost of money.

The yield on 10-year U.S. Treasury bonds touched 3% on Tuesday for the first time since 2014, after flirting with that level for a few months. As the benchmark neared, many investors worried increasingly whether stocks would plummet. And indeed, the Standard & Poor’s 500 index dipped 1.3% today after months of wavering, representing a drop of more than 8% from January’s high.

Interest rates determine to a large extent how investors will price stocks, so over time the stock market pivots on moves in the bond market. The two markets are separate, they often react off one another. Here’s how:

There’s another reason stocks react to the bond market. It’s more technical, but it explains some of those swift “corrections” that arise even in the midst of a strong bull market.

Interest rates help to tell you where stocks as a whole are going– maybe not next week or next month, but over a longer time frame.

What interest rates can indicate about the economy
If the economy is growing and whether stocks are likely to move higher, where interest rates are and where they’re going help you figure out.

When the economy is no longer able to grow, the Fed lowers rates, making money cheaper and encouraging consumer and business spending to reignite the economy. When rates are going down, corporate profits don’t grow as quickly or shrink, and investors bid down stocks on lower expected profits.

If interest rates go up, those future cash flows– most of which are way in the future– are worth much less today.

How people value that future dollar depends on interest rates. To offset a current rise in interest rates investors demand more future money.

If investors anticipate rapidly rising rates, they’ll push down stock prices– sometimes drastically– because the mathematical models say the value of a company’s future cash flows has declined. And if investors’ expectations change suddenly, resulting in spiking interest rates, stocks can plunge, even in the midst of a longer-term bull market.

The same thing happens with stocks. Investors price a company’s stock as the value of all its future cash flows discounted back to the present. Those future cash flows– most of which are way in the future– are worth much less today if interest rates go up.

The Federal Reserve tends to raise interest rates when economic growth is robust and inflation is rising. Interest rates peak near the end of an economic boom.

Interest rates determine to a large extent how investors will price stocks, so over time the stock market pivots on moves in the bond market. The Federal Reserve tends to raise interest rates when economic growth is robust and inflation is rising. How people value that future dollar depends on interest rates. To offset a current rise in interest rates investors demand more future money.

With interest rates at 5% an investor would accept equally $1 today or $1.05 next year. An investor would accept $1 today but would demand $1.06 next year to compensate for the rise in rates if rates rose to 6%.

What higher interest rates may signal about the future
Higher interest rates mean investors take a dimmer view of a company’s future profits.

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