A Complicated Relationship

Many people talk about how interest rates can affect bond prices.    However, rates can also affect stock prices.  Here’s a quick summary of the reasons behind that relationship

  • Interest Expense: Interest rates represent an expense for any company that uses credit. As interest rates rise so do the costs of borrowing. All else equal, that implies lower earnings and stock prices.
  • Lower Growth: Higher interest rates mean that fewer companies will be able to (or want to ) use credit. Less credit means less financing for investment, less leverage, and slower growth. All else equal, that implies lower earnings and stock prices.
  • Multiple Compression: Higher interest rates can make stocks less attractive relative to other investments like bonds. All else equal, that can cause the P/E multiple to compress. In other words, stock investors are willing to pay less for each dollar of earnings.
  • Discount Rate: Higher interest rates generally go hand in hand with higher inflation. Both things result in a higher discount rate (or more devaluation) against the future cash flows that stocks are expected to deliver. All else equal, that results in lower current stock prices.
Now stocks rose quite a bit last year despite rising interest rates.  That just goes to show that stocks and interest rates don’t always have a negative relationship.  Research by JP Morgan shows that stock prices generally aren’t impacted by interest rates until the 10 Year Treasury reaches about 5%.
With the 10 Year Treasury still under 3%, we could argue that stocks still have a runway for a continued climb.  Then again, there’s no hard and fast rule that says stocks must only go down when bond yields reach 5%.  A reversal could happen at any moment.
At the end of the day, it’s useful to understand how interest rates can affect stocks, but it’s also important to recognize that the relationship is not as simple as it is with bonds.  The relationship is, to say the least, complicated. And as such, it shouldn’t be relied on as sole indicator for when to buy and sell stocks.
Victor K. Lai, CFA
This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss. Victor Lai does not own any of the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own shares of the securities referenced in this posting.