Higher Interest Rates Are “An Excuse, Not An Explanation” For Stock Slide

My family and I were seated outside a restaurant for Sunday brunch. As we enjoyed our meal, a small bird landed at the next table. He pecked away at a bagel for a few minutes, then fluttered away. An older gentleman returned to the table and reached for the bagel the bird had enjoyed. We warned him that our feathered friend ruined his food. He shrugged and took a bite anyway. Noticing our surprise, he smiled and said, “I am French. It is not an excuse, just an explanation.”

The most commonly cited reason for the recent stock market correction is the fear that interest rates are set to move much higher. But contrary to the Frenchman’s witty remark, the consensus viewpoint is “just an excuse, not an explanation.”

Higher interest rates can hurt stock values in two ways. First, higher inflation-adjusted (or real) interest rates make bonds more competitive with stocks in terms of future potential returns. This often will result in stock price declines to boost the future potential return of stocks and keep them competitive in the eyes of investors vs. less risky alternatives. Second, fear of accelerating inflation will raise the inflation risk premium demanded by fixed-income investors, especially in longer-term bonds. This increases the yield offered by bonds and makes them more competitive with stocks. In addition, significantly higher expected rates of inflation (think several percentage points higher) can impair economic activity and harm corporate profits. Lower profits harm stock values unless investors are willing to pay more for every dollar of earnings.

So how have higher interest rates hurt stocks in recent weeks? To judge the impact of real interest rates, we look to the market for Treasury inflation-protected securities (TIPS). The longest-dated TIPS, which compete most directly with stocks for long-horizon savings, currently offer an annual inflation-adjusted return of 1%. This offered return level is virtually unchanged from a month ago and has fluctuated by only a few tenths of a percentage point since early 2016. So changes in real long-term interest rates don’t explain any of the stock market correction.