The Misleading Claim: Stocks are at record highs! The governments economic policies have clearly worked! The Refutation: The Federal Reserves policy of low interest rates, whether one is to approve of it or not, has an unintended consequence; it makes investment in NEW bonds highly unattractive. This is because bonds are similar to loans, and people dont make money from loaning capital unless they can charge interest. If interest rates, however, are held at a low rates (which the FED has done, at slightly above 0%), few will seek to invest in new bonds. Investors, instead, are likely to choose between investing in PRE-EXISTING bonds, which increasingly become scarce the more we avoid creating NEW bonds, or stocks. The key word here is stocks. As investment in new bonds becomes less attractive, STOCKS, as an alternative investment option, becomes MORE attractive. It is THIS reason why stocks are up. Yes, investors HAVE invested in stocks more so than previously, but that largely corresponds with gradual movement AWAY from bonds. As Forbes magazine indicates, if interest rates rise, bonds will begin to look attractive again and investors will return. This is because higher interest rates translates into NEW issue bonds with higher coupons. Its an interesting exchange, and its not without precedent. The opposite was occurring years ago, when interest rates werent nearly as low as they are now and fears over the 08 stock market crash were lingering, incentivizing investors out of stocks but into bonds. The Investment Company Institute reported that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have saw a massive $559 billion of inflows. But as the market hit its floor and investors could again choose between two options, things began to shift and low interest rates incentivized investors BACK into stocks. As the WallStreet Journal noted back in August of 2010, the possibility of substantial capital losses on bonds looms large in regards to buying new bonds when interest rates are expected to increase. If over the next year, 10-year interest rates, which are now 2.8%(in 2010), rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4%...the capital loss will be more than THREE times the current yield. As stated above, investing in new bonds, at a time when interest rates are expected to increase is unattractive. So when did our bond market GET so unattractive? Around 2009, our effective interest rates had fallen to near zero percent. At that point, the incline in the stock market also began. (See our corresponding charts) Conclusion: When people cite the present state of the stock market as supporting evidence for current government policy, be aware of the factors noted above. Stocks - alone - dont tell the whole story. ------------------- Sources: forbes/sites/mikepatton/2013/08/30/why-rising-interest-rates-are-bad-for-bonds-and-what-you-can-do-about-it/ m.us.wsj/articles/SB10001424052748704407804575425384002846058?mobile=y m.research.stlouisfed.org/fred/series.php?sid=FEDFUNDS&show=chart&range=10yrs&units=lin m.research.stlouisfed.org/fred/series.php?sid=DJCA&show=chart&range=10yrs&units=lin
Posted on: Fri, 19 Sep 2014 15:51:49 +0000
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