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The development of interest rates and the bond market influences what happens in the stock market. Intermarket analysis, a sub-area of technical analysis, deals with the relationships between the various markets.
The US Federal Reserve's announcement that it would gradually taper its monthly bond purchases and the prospect of a possible interest rate hike at the end of 2022 has led to weaker share prices on the stock market. So, what impact could a turnaround in interest rates have on bonds and stock markets?
Interest rate level influences the business development of companies
How interest rate impact stock markets? By raising interest rates, the price of money goes up. This has an impact on companies. At a certain point, rising interest rates have a negative impact on corporate profits, which weighs on stock prices. This is because most companies need outside capital to carry out their business activities, for example, to finance machines, preliminary products, or raw materials. As interest rates rise, so does the interest burden on borrowed funds. Ultimately, higher borrowing costs reduce profits. If a company's profit expectations drop, however, investors will only be willing to pay a low price for its shares.
The opposite is true for interest rate cuts; the cost of borrowing goes down. Therefore, falling interest rates are usually favorable conditions for the sales and profit development of companies.
Stocks and bonds compete
Changes in interest rates also have an impact on the relationship between the competing asset classes of bonds and equities. Rising interest rates on bonds that have already been issued tend to lead to falling prices, which increases their yield. Conversely, falling interest rates usually cause the prices of bonds to rise as investors seek those bonds that offer an even higher interest rate.
The following example should clarify this: An investor intends to buy a bond with a term of 10 years and an interest payment of 1.0% pa. If the general interest level rises to 2.0% due to an interest rate increase, a newly issued bond with 2.0% pa based on the market level, with otherwise the same parameters, would a more advantageous choice. The bond with the lower interest rate can now only be sold at a low price in order to compensate for the difference in yield to the newly issued paper.
If investors consider bonds to be disadvantageous in comparison to the returns expected from shares due to the low-interest rates, they are more likely to invest in company shares. However, if interest rates rise, higher returns can be achieved again with bonds, making them more attractive compared to the riskier asset class. Investors will then be more inclined to invest their money in bonds. Thus, at a certain point, rising interest rates favor capital flows out of equities and into bonds. The increased interest in selling shares in such an environment causes their prices to fall.
Commodities defy rate hikes
The commodities sector made an impressive comeback at a certain point. Strong price increases for crude oil and other commodities, such as raw materials, have also contributed to the sharp rise in inflation rates. The reason was the sharp jump in demand during the recovery from the Corona crisis, which supply could hardly cover. After all, comparatively little was invested in the raw materials sector in the past decade. In this respect, rising interest rates are actually having a positive effect since financing investments to develop new sources of raw materials is becoming more expensive. This indirectly makes existing resources more valuable. Confidence in commodities is correspondingly high, with crude oil as one of the most important representatives.
Central banks communicate more clearly
Larger changes in interest rates usually precede a change in the trend of stock prices. Therefore, it makes sense to watch for signs of a possible reversal in interest rates. While the central banks still caused one or two surprises in this regard at their meetings before the turn of the millennium, they have switched to clear communication since the financial crisis of 2008. Announcements in advance and a high degree of transparency should give the financial markets time to adjust to a change in the framework conditions and avoid major upheavals.
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