Thursday, June 22, 2006

Reader Email: Why Higher Rates Hammer Stocks

You Ask Why do stocks take a beating when interest rates rise?

We Reply For the love of God, what are you trying to get us to do: re-write War and Peace? There's plenty of stuff available on the web to answer your question, so we'll just leave you with a couple of bite size nuggets to take home. Armed with this rudimentary information, you should be ready to talk dirt with your Econ professor in no time.

1. When interest rates go up, the Fed "tightens" money supply by selling bonds on the open market. This pulls money out of circulation (buyers of bonds get a piece of paper; government gets your cash) and yields on bonds/"safe" investment classes go up. This makes stocks look less attractive b/c the average investor can take in 5-6% on this more conservative asset class and bypass the risk associated with equity investing.

2. Higher rates cripple consumers + corporations alike: consumers get body slammed since higher rates = higher borrowing costs (this is important). This country was built on cheeseburgers and credit, so higher rates are not to be taken lightly. Higher rates mean less people buying homes and borrowing capital to augment their standards of living, for one thing. Higher rates, likewise, hurt corporations because it makes their financing activities more expensive. Capital expenditures get pushed back, investors take notice, and stocks take a beating.

3. Investor sentiment is drastically impacted by higher rates: once rates climb past a certain threshold, safer investments like bonds begin to look more attractive simply because the yield is higher and closer to that of stocks, without the risk associated with the latter, of course. If a bond can give you 6%, you're only 400 basis points [bps] away from the historical rate of return stocks are supposed to reward you with (about 10.3%) over the long term. Bonds don't keep pace with inflation the same way stocks do, but sometimes people just want a steady income without the ulcer. If you want the sex, though, only stocks will deliver.

4. Rates affect the way banks make money. Banks have a killer business model, we think: commercial banks make money off a spread called net interest income. All it means is this: Banks pay you a paltry rate of return (the "short term" rate) on your deposits but ring the register with the interest payments they receive for the loans they facilitate for their customers (at the "long term" rate). The closer the spread between the rates, the less mula your friendly local bank collects. On the other hand, banks are not stupid: most of them are taking in piles of revenue from non-interest related activities, such as investment advice fees.

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