Stocks dropped on Friday, Monday, and Tuesday after last Friday’s announcement that inflation came in higher than expected. The net drop was enough to officially put the S&P 500 in bear market territory. A key driver of that decline was the worry that the Federal Reserve may have to raise rates by 100 basis points — one full percentage point — in order to start to tame inflation.
On the surface, a 1% increase in rates may not really seem so bad. It certainly doesn’t seem crazy enough to justify a massive sell-off after the market had already dropped as far as it already had in 2022. After all, a 1% increase in rates works out to an extra $100 per year — about $0.27 per day — for every $10,000 borrowed. The bigger problem isn’t really on the borrowing side of a 100-basis-point increase in rates, it’s on the investing side of such an increase.
Why are investors so worried about that possible rate increase?
When big companies borrow money — or mortgages are bundled into mortgage backed securities — that money is usually lent out by external investors who buy it up as bonds. New bonds are generally issued at the current prevailing interest rates, while already existing bonds float in price based on the market forces. Note that while the Federal Reserve doesn’t directly control longer-term or corporate-borrowing rates, it certainly influences them.
An investor looking to buy a bond can choose any available bond, whether it’s a newly issued bond or one that has already been on the market. As a result, consider the difference between a new 30-year bond that offers a 4% coupon yield after a 100-basis-point rate increase and a week-old 30-year bond that offered a 3% coupon yield before that increase. If you could choose between 4% per year interest on your money or 3% per year interest for otherwise nearly identical securities, which would you choose?
Obviously, if the two were offered at the same price, you’d choose the 4% bond over the 3% one. So what happens in practice is that the bond offered at 3% interest before the rate increase falls in price to offer a comparable potential lifetime return as the newer 4% bond.
The math behind how far that 3% bond falls is kind of complicated, and a shorthand estimate is known as the modified duration of the bond. For a 30-year bond at a 3% coupon rate when comparable rates suddenly rise to 4%, the modified duration is around 19.6 . Or in other words, that one percentage point instant increase in rates would translate to around an immediate 19.6% drop in market value for that 3% bond.
That is the key driver behind the massive pain in the market driven by that rate fear. And it’s not just an academic exercise. Last Thursday, before that higher than expected inflation number came out, 30-year Treasury bonds offered a 3.18% yield. By this Tuesday, 30-year Treasury bond rates had increased to 3.45%, just on the fear that the Federal Reserve may raise rates more than previously expected.
When bonds get cheaper because of interest rate increases, they become relatively more attractive than stocks, driving at least a partial shift from stocks to bonds.
The institutional imperative only makes it worse
On top of that natural shift, imagine you’re an institutional money manager who is required by your charter to keep a certain balance between stocks and bonds. A common such ratio could be the old-school 60% stocks, 40% bonds rule for retiree-focused portfolios. If all of a sudden, a big chunk of your bond portfolio fell by nearly 20% because of that shift in interest rates, your portfolio may have fallen out of balance. In that case, it’d be because your bond holdings dropped too far.
That shift would force you to sell stocks to buy bonds to bring your portfolio back in balance, putting additional pressure on what’s already primed to be a rough stock market. Put it all together, and it starts to get much clearer why stocks have been taking it on the chin based on the mere fear of a 1-percentage-point rise in interest rates.
Hang in there
If there’s a bright side to this madness, it’s that a bond’s modified duration depends a lot on its initial coupon rate. Take a similar 30-year bond but start its initial coupon at 4%, and its modified duration drops to around 17.3. That’s still bad, but less awful than the 3% bond. Or in other words, the earliest rate increases tend to hurt the most, because prevailing interest rates began from lower starting points.
In addition, if being more aggressive now means the Federal Reserve can actually make headwind in fighting inflation, it could also mean that future rate increases don’t need to be quite as large. That would ultimately translate to less downward pressure on stocks, thanks to less downward pressure on existing bond values from smaller rises in rates.
So hang in there, as long as you’re personally prepared to handle a rough market. There’s good reason to believe that this, too, shall pass and that the longer-term future could be less rocky than the recent past has been.
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