WHY DO ASSET PRICES FALL WHEN INTEREST RATES RISE?

We have seen a lot of turmoil and disruption in 2022. The war in Ukraine, continued global supply chain interruptions, and soaring inflation have made headlines, but possibly the most dramatic event has been the relentless push by the Federal Reserve to increase interest rates.

 While rising interest rates will generally cool down the economy, it can also lead to decreasing prices of popular investment assets like stocks, bonds, and real estate. 

STOCKS

One reason stocks might decline is due to slower earnings growth. As the cost to borrow increases, companies are more reluctant to invest in their own growth, which means future earnings could decline.  This is especially true of rapidly growing technology stocks.

Stock prices could also decline due to the mathematical equations that professional investors use to help determine the reasonable current value of a stock. In such equations (including the Dividend Discount Model and the Discounted Cash Flow Model), future dividends or earnings are discounted back to today’s value using current interest rates. As the interest rate increases, the denominator of the equation gets larger, meaning the stock value gets smaller (1/3 is smaller than 1/2).

BONDS

Bonds pay a fixed rate of interest, and as rates rise older (lower rate) bonds are less attractive. The only way for a lower yielding bond to compete is to lower the purchase price to the point where the effective yields are equivalent to a newer bond with a higher interest rate.

To illustrate, let’s assume two bonds both have an initial price of $100 and the same maturity date. 

The older one, Bond A, has a 4% interest rate and the newer one, Bond B, a 5% interest rate. Someone owning Bond B would get $5/year in interest (5% of $100 face value), but Bond A owner would only get $4/year. A reasonable investor would demand the same $5/year interest for the same $100 investment.

Thus, the solution is to lower the price of Bond A to $80. At that price, a $100 investment would buy 1.25 bonds. Each $100 bond investment will now pay $5/yr. interest. (This example is an oversimplification. Actual bond price calculations are much more complex.)

REAL ESTATE

Like every other asset class, Real Estate, is governed by the law of supply and demand. As interest rates rise, mortgage affordability goes down and buyers have to make difficult choices. Less home can now be purchased for the same monthly payment.

Let’s assume a home buyer can afford a $3,000/mo mortgage payment. If they purchased a home last year at 3% rates, they could have afforded a $700,000 mortgage. However, if they were to buy now with rates at 6%, they could only afford a $500,000 mortgage (a nearly 30% drop in affordability).

With fewer buyers able to afford the higher prices, real estate sellers might be forced to reduce prices to attract offers.

EVERYTHING ELSE

While the above information is true, it’s only part of the story.  Interest rates certainly have a large impact on asset prices, but there are also many other forces at play and it’s hard to predict the timing and degree of price changes. 

The only thing we know for sure is that we’re in a new economic environment and the rapid rise in interest rates has had profound impacts.