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WHAT WILL AN INTEREST RATE HIKE DO TO STOCK PRICES?

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WHAT WILL AN INTEREST RATE HIKE DO TO STOCK PRICES?

May 29 2015, 07.50am GMT

STOCK.com

Stanley Fischer, the Federal Reserve’s vice chairman, said that the Federal Reserve expects to raise short-term interest rates from 0% to about 3.25% to 4% within the next 3 or 4 years.

Fischer added that this is not his personal guess, but the central target which the Fed economists are using.

If short-term rates had to reach that mark, history has shown that ten year Treasury bond rates may increase from the 2% today to around 4.25-5%. From these two seemingly simple events, a massive domino-chainlike effect will resonate across the stock market, and world-wide in fact, and we can expect to see stock prices declining.

How and why will this happen?

Simply put, by increasing the interest rates on ten year Treasury bonds from 2% seen today to 4% which is in line with the Fed’s expectation, this would cut the present stock market value by 50%.

There are very few or no people who would purchase a 2% Treasury bond when in fact they could buy a 4-5% Treasury bond instead. The Treasury bonds that you now own will be marked down, hugely, in order to compete.

The bottom line is that no one would want a corporate bond of 5% with a default risk when they could rather buy a Treasury bond of 5% without the risk. History has shown that to compensate for corporate bond risks, these bonds would need to yield a lot more than the equivalent Treasuries to compete. That said, they too will also be marked down considerably.

It’s easy to forget that during corporate earnings news and noise, buybacks & various other deals, most of the time the stock market value has nothing at all to do with what stocks or companies are doing.

Instead, half of the value of stock markets lies in the cost-of-capital. Said differently, this refers to the interest rate you can possibly earn by not investing in stocks while putting your money somewhere else instead.

So when Treasury bonds interest rates increase then stocks become, in comparison, significantly less attractive. These prices have to drop to hold the similar relative appeal.

If we base this on Wall Street’s standard financial model, increasing the ten year Treasury bond interest rate from 2% seen today to 4%, in line with what the Fed expects, this would cut stock market present value by almost half.

With that said, this is neither a guesstimate nor a forecast nor an opinion, but rather what will happen when the vice chairman of the Fed’s predictions he offered are plugged into the standard Wall Street model used for valuing stocks.

 

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