Alright folks, we saw a substantial correction in the market this week. So, why is stock market down?
Well, if you are not seasoned with economic terms like inflation, interest rates or bond yields, then you may get a little confused when reading up online.
Because they may just be talking about the same or similar things.
To understand this, you must know that these 3 items, interest rates, inflation and bond yields are all inter-related.
I have used a blue line to show a general direct relationship between each two elements, and a red line to signify an inverse relationship.
Anyway, we are not going through the entire course on economics here. Other factors outside of these 3 variables can alter the way they behave as well. So this will be a very simplified explanation, to help you understand what’s going on in the market.
With that understanding, let’s take a look at each of the pairs first.
Why Is Stock Market Down: Interest Rates and Bond Yields
First, consider interest rates and bond yields.
Just for everyone’s sake, a bond is basically an instrument of debt issued by companies or the government that investors, or so called bondholders, can buy in return for coupons or interest payments to these investors.
For simplicity and to avoid confusion, take the bonds we are describing here throughout the article as government or treasury bonds, unless stated otherwise.
So for example, if a $100 bond pays $5 coupon in a year, then the bond yield is 5%.
Since bonds are tradable assets in the market, their prices will change according to demand and supply. Thus, affecting the expected yield that investors will be getting.
To illustrate this, say in a rising interest rate environment, newly issued bonds will offer higher yields.
As the Federal Reserve raise the interest rates by selling more bonds in the market, it will increase the supply. This will reduce the price of treasury bonds.
Treasury yield is a function of the interest payment over the bond price. Therefore, when bond prices decline, treasury yield will increase.
Also, existing corporate bond prices decline because investors expect higher yield from them as well. Otherwise, why would they want to invest in them, when they can buy those newly issued bonds of higher yields.
In short, interest rates and bond yields are directly correlated. A rise in interest rate will cause a rise in bond yield.
Why Is Stock Market Down: Inflation and Bond Yields
Now take a look at inflation and bond yields.
Well, inflation erodes the purchasing power of a bond’s future cash flow. In another word, inflation will reduce the value of coupons or interest payments in real terms since it can buy lesser goods and services.
So, the higher the current rate of inflation, or the higher the expected future rates of inflation, the higher the bond yields will be required from investors, to compensate for the eroding purchasing power or inflation risk in the future.
So, in short, inflation and bond yields are directly correlated. A rise, or an expected rise in inflation, will cause a rise in bond yield.
Why Is Stock Market Down: Interest Rates and Inflation
Now, what about the relationship between interest rates and inflation?
Well, this pair generally has an inverse correlation.
As interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend. This causes the economy to grow and inflation to increase.
On the other hand, when interest rates rise, consumers tend to save more as they can get higher returns from their savings. So wIth less spending, the economy slows and inflation decreases.
Well, there’s another whole quantity theory of money. It talks about how interest rate affects money supply, hence the real value of money, and consequently, the inflation impact. Again, this is not an economic class, we will not go through all these.
Just know for now that interest rates and inflation tend to have an inverse relationship.
Putting All Together
Now, back to the triangle. This is where it gets tricky, and we will use it to explain the market correction recently.
First, notice the potentially confusing relationship among the 3. Let’s say we increase the interest rate, bond yields should rise. But increasing the interest rate will reduce inflation, and cause bond yields to drop instead. So you see the contradiction here?
Well, the gist is that the impact of increasing interest rates will have a different impact on the bond yields and inflation across different time frames.
Let’s say we go back to during the initial period of the pandemic outbreak back in 2020. Where the federal reserve drastically reduced the interest rates to stimulate the economy, which caused the bond yields to drop. Remember the direct correlation between interest rates and bond yields.
On the other hand, the decline in interest rate did not bring immediate inflation. It takes time for the spending to trickle down the whole economy. As such, the effect of a potentially rising inflation on bond yield is non-existent at that moment in time.
Explaining Why Is Stock Market Down
And that brings us to the market correction we observed recently.
Now that it has been roughly a year since the stimulus and low interest rate environment kicks in, the fear of inflation starts to surface.
Furthermore, some believe that the coming $1.9 trillion stimulus package will be too large for the economy to handle.
Coupled with the already near-zero interest rates, people start to fear that inflationary pressure will surface real soon.
As discussed earlier, as inflation rates increase, bond yields tend to rise.
Furthermore, high inflation rates are not something that the Fed would like to see as well.
Because generally speaking, too high an inflation rate is not good for the economy. Consumer will reduce their spending due to the rising prices of goods and services. Businesses are impacted not only by rising costs, but also lower consumer spending, thereby slowing down the whole economy.
Therefore, such inflationary pressure can signal the Fed to increase interest rates, to curb the rising inflation rates.
So, all in all, there’s potentially a double impact.
Not only will rising inflation and interest rates cause bond yields to increase, making it less attractive to invest in stocks.
But also, higher interest rates will also translate to higher cost of borrowing for businesses. This will limit corporations’ earnings and growth prospects, thus, making stocks less appealing to invest.
So, stocks, especially tech stocks with long-term growth prospects, are very sensitive to changes in interest rates.
That explains the market selloff and correction this week.
Effects of Anticipation
However that does not mean that people are rushing to buy bonds due to a few reasons.
For instance, people are anticipating that the Fed will be flooding the market with more bonds, depressing its price. So, investors will be thinking, why the hurry to buy now, why not wait for lower prices and higher yields.
Another reason is that people are anticipating inflation. The actual inflation hasn’t happened yet. So, as soon as inflation comes, yield will climb higher. The current bond yield will not be appealing enough. So they rather stay out of bonds for now, and wait at the sideline for the time being.
So, now you see, even with the explanations we have done earlier, it may not be so straightforward when analyzing exactly what happened to the market. Because, there’s so much anticipation and speculation going on.
And again, this is a very simplified explanation. The way the Fed influences the market can come through using varying tools. So the actual impact, together with other external factors, can affect the stock market very differently, as seen here.
What Should Investors Do
Okay, now that you have understood why is stock market down. Then you may ask, what’s in it for you investors out there?
Well, with the speculation and fear looming in the market, the first obvious thing to do is, don’t panic. Rather look at this as an opportunity.
The second thing to do during the market correction is to start tracking investment opportunities more closely. Or perhaps even loading up those great tech companies that you might have missed during the 2020 recovery.
However, that’s not to say that we should ignore inflation entirely. Serious inflation can really affect real returns, so do continue to monitor the economy.
Also, a word of caution. Valuations can still remain high for many stocks even after the market correction.
Nonetheless, there are still opportunities to get in at better prices for those great companies. That also include those that are not in the tech sector, but were pulled down by the overall market.
To wrap it up, as a long term investor, yes, interest rates and inflation may affect your returns. But if what you own are great companies, then there is no reason to get rid of them, at least at this point in time.
These are just cycles in business and the economy.
Eventually, your investments that are bound to do well will still do well in the long haul.
So, use such market correction as an opportunity.
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