NEW YORK (AP) – Yes, it is possible to have too many good things, and that is exactly why stock markets around the world are so volatile.
Optimism for an economic recovery is soaring after a year of coronavirus-induced misery. But expectations of stronger growth – plus the higher inflation that might come with it – are pushing interest rates up, forcing investors to reconsider how they value stocks, bonds and more. all other investments.
When trying to determine the value of anything from Apple stock to an unwanted bond, the financial world begins by comparing it to a US Treasury bond, which the government uses to borrow money. For years, yields have been extremely low for Treasurys, meaning investors have gained very little interest in owning them. This in turn helped make stocks and other investments more attractive, driving up their prices. But when Treasury yields rise, the downward pressure on the prices of other investments also increases.
All eyes have been on the yield on the 10-year Treasury bill, which has climbed above 1.50% this week after starting the year around 0.90%. Here’s a look at why the move rocked the financial world, including the worst week for the Nasdaq composite since October:
WHY ARE TREASURY RETURNS INCREASING?
Part of the reason is rising inflation expectations, perhaps a bond investor’s worst enemy. Inflation means that future bond payments won’t buy as many bananas, college tuition minutes, or anything else that goes up in price. Bond prices therefore tend to fall when inflation expectations rise, which in turn pushes their yields up.
T-bill yields also often follow expectations of a stronger economy, which are on the rise. When the economy is healthy, investors feel less of a need to own treasury bills, which are considered the safest investment possible.
WHY DO FALLING BOND PRICES MEAN RISING RETURNS?
Let’s say I bought a bond for $ 100 that pays 1% interest, but I’m worried about inflation rising and I don’t want to get stuck with it. I’ll sell it to you for $ 90. You get a ROI of over 1% because the regular payments from the bond will always be the same amount as when I owned it.
WHY ARE EXPECTATIONS FOR INFLATION AND GROWTH INCREASING?
It is hoped that the coronavirus vaccines will allow savings to vibrate this year, as people will feel comfortable returning to stores, businesses will reopen, and workers will find jobs. The International Monetary Fund expects the global economy to grow 5.5% this year after falling 3.5% last year.
A stronger economy often coincides with higher inflation, although it has generally been trending downward for decades. Congress is also set to inject an additional $ 1.9 trillion into the U.S. economy, which could further boost growth and inflation.
WHY DO PRICES AFFECT THE PRICES OF SHARES?
When trying to price a stock, investors often look at two things: how much money the company will generate and how much to pay for every dollar of that cash. When interest rates are low and bonds pay little, investors are willing to pay more for this second part. Consider a stock like Apple or some other Big Tech company, which is likely to continue to generate large amounts of cash for many years to come. It is worth the wait a long time if a 10-year Treasury pays less in the meantime.
AND NOW THAT THE RATES ARE ON THE RISE?
The recent surge in yields is forcing investors to reduce what they are willing to spend for every dollar in future company profits. Stocks with the highest prices relative to earnings are hit hard, as are stocks that have been offered for their expected earnings in the future. Big Tech’s actions are in these two camps. Dividend-paying stocks are also suffering as income-seeking investors can now turn to bonds, which are safer investments.
The ultimate worry is that inflation takes off at some point, resulting in much higher rates.
ARE NOT INTEREST RATES ALWAYS REALLY LOW?
Yes, even at 1.50%, the 10-year Treasury yield is still below the 2.60% level it was two years ago or the 5% level of two decades ago.
“The problem isn’t that the 10-year is at 1.50%,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “It’s that it went from 1% to 1.50% in a few weeks, and what does that mean for the rest of 2021.”
Ma thinks it could continue to rise above 2% by the end of the year, but he doesn’t see it reverting back to the old normal of 4% or 5%, which would force a reassessment again. most important of the markets. Until it becomes clearer, however, he says he’s looking to keep the stock market volatile.
ARE NOT STOCKS REALLY HIGH YET?
Yes. Despite the recent market pullback, major US stock indices remain close to all-time highs set earlier this month. The benchmark S&P 500 and the Nasdaq each hit all-time highs on February 12. The Dow Jones Industrial Average set a record on Wednesday. And the Russell 2000 Small Business Index hit an all-time high on February 9.
DIDN’T THE FED SAY IT WILL KEEP INTEREST RATES LOW?
Yes. The Federal Reserve has direct control over short-term interest rates, and President Jerome Powell told Congress this week he was in no rush to raise them. It also doesn’t plan to cut its $ 120 billion in monthly bond purchases used to put downward pressure on long-term rates.
Powell said the Fed will not raise its benchmark interest rate, now at an all-time low of zero at 0.25%, until inflation rises slightly above its target level of 2%. Powell told Congress that while price increases may accelerate in the coming months, those increases should be temporary and not a sign of long-term inflation threats.
IS WALL STREET ALWAYS OPTIMISTIC?
Yes, and one of the reasons is that many investors agree with Powell and expect inflationary pressures to be only temporary. Hopefully this should keep rates from climbing to dangerous levels.
Additionally, after a dismal 2020 for most companies, investors expect corporate profits to improve in the second half of this year, as coronavirus vaccination efforts expand and the economy. will gradually begin to approach normal. If profits rise, stocks may remain stable or even rise.
ARE SOME COMPANIES DOING WELL WHEN RATES ARE UP?
Financial companies, especially banks, have won recently because rising rates can mean larger profits on a variety of consumer loans, including mortgages. And if rates rise due to inflation concerns, energy companies could benefit if the prices of oil and other commodities rise as well.
Overall, however, rising interest rates are a drag on businesses because they make borrowing more expensive. This is especially painful for businesses like real estate investment trusts or REITs, which require a lot of money, and often debt, to operate.
People who rely heavily on credit can also cut spending, which could have a ripple effect on all kinds of businesses that rely on consumer spending.