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Rate fears for equity markets

Economies are resilient to rising interest rates – financial markets less so
March 9, 2021

On Black Monday 1987 I was a graduate trainee at a stockbroking firm. As shares collapsed and the mood swung between panic and mortification an old broker piped up. “Call this a crash,” he said. “You should have been here in 1974. We thought equities were going to become worthless.” “What’s that old fart on about?” I thought.

Today, dear reader, I am that old fart. When I hear talk of the danger of rising interest rates, I remember when rates really rose.

But you have to be quite old to share this recollection. The last time the Bank of England raised Bank rate above 5 per cent was in 2007. And the fed funds rate last rose above 3 per cent in 2005. These rises are more temporally distant from us today than 1974 was in 1987. They mean that no graduate under 35 has seen a serious rate rise during their working lifetime.

Which is one reason why the mere possibility of one is worrying. An entire generation of traders has no practical experience of seriously rising rates. For them, such a prospect is troubling precisely because it is unfamiliar.

And, in fact, they’ve good reason to be worried.

Here, we must distinguish between the real economy and financial markets. The Federal Reserve estimates that a one percentage point rise in the fed funds rate would cut GDP by around half a percent after two years, relative to what it would otherwise be. Bank of England economists estimate a similar effect for UK rate rises. In macroeconomic terms, then, rate rises are no big deal.

For financial markets, however, things are different. One reason for this lies in the basic maths of bond markets. Especially at low yields, even a moderate rise causes big capital losses. A percentage point rise in gilt yields – which would only take them back to early 2016 levels – would see holders of 10-year gilts lose almost 10 per cent and holders of 20-year ones lose over 17 per cent. Granted, the Bank of England is now a huge holder of such bonds, but it is not the only one.

There are also dangers for equities, even beyond the fact that higher rates would cause lower growth and earnings downgrades.

One problem is that, all else being equal, higher bond yields would mean that future cash flows are discounted more heavily, thus hitting the prices of growth stocks. It might be no accident that the recent rise in US yields has been accompanied by a drop in Tesla’s share price. Luckily, though, all else need not be equal. If bond yields rise at the same time as investors’ appetite for risk increases – as very often happens – then the net impact on growth stocks would be small and maybe even positive. What equity investors have to fear is a rise in yields that occurs for other reasons, such as expectations of inflation and tighter monetary policy.

There’s another danger. It’s possible that share prices around the world have been pushed up by a 'reach for yield': a lack of return on cash has forced investors into equities not because of confidence in growth or valuations, but simply in the desperate hope of any type of return. If rates rise, we could see this process go into reverse. And not just for equities, but for higher-yielding bonds, too.

It’s hard to say how much of a factor the reach for yield has been in supporting share prices. What we do know is that experiments conducted by Harvard University’s Carmen Wang and colleagues have found that a reach for yield easily emerges in laboratory conditions. So we cannot rule it out as a factor in the real world.

But there’s another problem. For investors, risk doesn’t just emerge from the economy, companies and central bankers. It also arises from other investors. Even if an investor is relaxed about the possibility of the impact of higher rates, he cannot be at all confident that others will be. Which poses the danger that bonds or equities will sell off because of fears about others’ fears – a threat that could materialise long before rates actually rise. Asset prices are driven by beliefs about beliefs. For this reason, as the Nobel laureate Robert Shiller showed, equity prices are much more volatile than the underlying reality of dividends.

Which is the point. The real economy is reasonably resilient to changes in interest rates – but financial markets are much less so.