Stocks & Bonds Trade Lower as Interest Rates Continue to Rise
Monthly Market Summary
Stocks Decline for a Third Month as Rates Reach Highest Levels Since 2007
The S&P 500 gained more than 20% through the end of July but has since declined 8.3% over the past three months, bringing its year-to-date gain to 10.6%. A significant factor behind the recent equity market sell-off has been the sharp rise in interest rates, with the 10-year U.S. Treasury yield climbing +1.25% from mid-July through mid-October and rising above 5% for the first time since 2007. This surge in Treasury yields continues to weigh on both stocks and bonds as valuations adjust to a world of higher interest rates. Small-cap stocks underperformed large-cap stocks by over -4.5% in October, and defensive sectors outperformed cyclical sectors. In the credit market, bonds posted another month of negative returns. The following paragraphs discuss why stocks and bonds tend to experience pressure during rising rate periods.
Why Rising Interest Rates Cause Bonds & Stocks to Trade Lower
Consider two bonds: Bond A was issued one year ago and pays a fixed 2% interest rate, and Bond B was issued one month ago and pays a fixed 2.5% interest rate. On an annual basis, Bond A yields $2 per $100 of principal, while Bond B yields $2.50 per $100 of principal. Assuming all else is equal, a rational investor would choose Bond B because of its higher yield. To attract investors to buy Bond A and align its yield with Bond B’s 2.5% yield, the market will adjust the price of Bond A lower. In our example, the price of Bond A will decline so that its fixed $2 interest payment corresponds to a 2.5% yield. At this adjusted price, investors would earn a 2.5% yield with Bond A, making them indifferent to choosing between Bond A and Bond B.
Rising interest rates also cause stocks to trade lower. As interest rates climb, bonds offer a higher expected return, which makes bonds more competitive with stocks. The higher expected return on bonds can prompt investors to sell stocks and buy bonds, causing stock prices to decline. In addition, higher interest rates increase borrowing costs, which can slow economic growth and reduce corporate profits. If investors expect slower earnings growth, stock prices may decline as investors seek lower valuations to offset the heightened earnings risk.