Over the past month, the 10-year Treasury bond yield has jumped from under 3.00% to 3.23%, sending tremors through the equity markets. By now you’ve heard/read/thought about the usual suspects.
As interest rates move higher, equity investors searching for income finally (finally!) have a viable alternative to stocks.
As interest rates move higher, consumers using borrowed funds to purchase homes, cars, and stuff on credit cards will have to pay more, which should curb their economic appetite.
As interest rates move higher, stock valuations drop because future cash flows (dividends plus capital gains) are worth a little less than they were before.
As interest rates move higher, investors become fearful of how far they will go, making them risk averse.
All of this weighs on equities.
But don’t forget the Fed is doing more than raising rates, and it’s feeding the frenzy.
The central bank created the equity bull market monster out of thin air when it started printing money to buy bonds in March 2009.
By pledging to purchase more than $1 trillion worth of mortgage-backed securities, the Fed gave new life to banks, which owned a bunch of those bonds. But the Fed wasn’t done.
It kept buying more, eventually amassing more than $4 trillion worth of bonds, driving down long-term interest rates and putting more hard cash in the hands of banks. The Fed then paid the banks interest on their cash, guaranteeing bank profits.
Since the Fed didn’t care at what price it purchased bonds, medium and long-term interest rates dropped like a rock. As long as the Fed, with its printing press bank account, kept buying, then rates remained low.
Today, the Fed isn’t buying. And while it isn’t exactly selling, the central bank is shrinking its balance sheet, and that activity is starting to have an effect.
I wrote about this back in the August issue of our flagship newsletter Boom & Bust, “Will the Fed Finally Kill This Bull?”
