It seems unlikely that interest rates will skyrocket from here, but because of how stock market valuations are calculated, even a moderate move higher could have a significant impact on the market. Over the last decade, the 10-year Treasury yield has fluctuated between 0.50% and 3.65%. And, while that yield is still near historic lows, rates have more than doubled since last spring’s economic shutdown, and there are several potential catalysts for further increases.
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How much is the market worth?
At the most basic level, remember that when investing, you are laying out cash today for the promise (or hope) of a cash inflow in the future. Payments in the future are less valuable than money in hand today, so you need to “discount” those future payments in order to see if the investment makes sense. Therefore, the value of any investment is heavily dependent on the “discount rate” you use, which is a function of A) the likelihood you actually receive those future cash flows and B) the risk free rate.
In the stock market, the likelihood of receiving future cash flows is reflected in the equity risk premium (ERP), while the 10-year Treasury is generally used as a proxy for the risk free rate.
That means that if the yield on the 10-year Treasury increases, the value of your future cash flow falls, which all else being equal makes the stock market less valuable. A recent study by Fidelity estimated that if the discount rate increases by 1%, fair value for the S&P 500 falls by 800 points. In other words, all else being equal, an instantaneous 1% increase in the 10-year Treasury could result in an 800 point drop in the S&P, which would be about a 20% decline, which means stocks would fall into a bear market.
So as you can see, interest rates matter quite a bit for stock investors.
But will rates go higher?
There are certainly a number of reasons why rates may stay low. These include continued high unemployment levels, a weak global economy, a renewed surge in COVID cases, and central banks focused on holding down borrowing costs and providing liquidity to financial markets.
So given all that, what might cause rates to move up? Well, for starters, the economy could rebound faster than expected. The CARES Act passed in March 2020 is widely credited with providing support for the economy, even though the National Bureau of Economic Research estimates that only 40% of stimulus checks were actually spent. With the Democrats soon to be in control of the White House, as well as Congress, the odds of additional fiscal stimulus have increased, which could spur stronger economic growth.
Unusually for a recession, savings rates have also increased, leaving some Americans with dry powder once the pandemic eases. In fact, some estimates indicate that Americans have saved more than $1 trillion during the pandemic. It also seems likely that there is significant pent-up demand for “normal” activities that have been unavailable because of COVID, including things like travel, movies, dining out, and entertainment. This potential spending surge could prompt stronger economic growth as well as potential inflation for some goods and services. Stronger growth and higher inflation could in turn lead to higher interest rates.
Finally, although the Federal Reserve is currently committed to keeping interest rates low, changes to its approach could eventually sow the seeds for higher rates. The Fed has already announced that they are shifting to measuring inflation across cycles, and that they would be willing to tolerate higher inflation for a time following a period of low inflation. Since inflation is a key component of interest rates, if the Fed is willing to let inflation run a little higher than market participants are accustomed too, higher interest rates could follow.
How to profit from higher rates
If interest rates do increase, investors will face both opportunities and risks, because while higher interest rates are a negative for the stock market as a whole, there are some companies and sectors that would benefit, while others are poised to suffer.
Financial companies make money by taking in deposits and then lending money out at higher rates, and a very low interest rate environment negatively impacts their profitability. For instance, in their Q3 earnings release Charles Schwab (SCHW 0.11%) reported a 10% year over year decline in revenue, due to “the overall decline in both short- and long-term rates.” But that also means that if rates revert to higher levels, Schwab can report better financial performance even without making operational improvements.
While financials might benefit from a higher rate environment, companies with heavy debt burdens could face difficulties, as their cost of capital could increase alongside interest rates, resulting in a decline in profitability or even potential solvency issues. For instance, in the gaming sector, Caesars Entertainment (CZR) has more than $15 billion in long-term debt, while Wynn Resorts (WYNN 0.38%) has nearly $13 billion. Caesars and Wynn are just two examples; from there you’ll want to screen for companies with heavy debt burdens that could potentially be impacted by rising rates. That approach, combined with a focus on financial companies that would benefit, could leave you well positioned for an unexpected surge in interest rates.
