3 Ways Rising Interest Rates Change the Game

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It seems that the Treasury bond market, which has been incredibly strong this year, might be topping out. If we look at shares of the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT), we find that the fund peaked at the end of May and pulled back, and after trying to make a new high on Monday, it violently reversed without doing so on Tuesday and Wednesday. This is a sign that the Treasury bond trade could be over, and this means that we can see game-changing market effects. Here are a few of them.

1. Bonds will weaken more generally

If the Treasury market weakens, then bonds in general will weaken, as well, because other bonds are often valued relative to the Treasury market. For instance, a low-risk corporate bond might fetch 1 percent more per year than the Treasury bond of the same duration, and if that bond’s interest rate rises, then so will that of the corporate bond. We can see this impact high-yield bonds, foreign bonds, and even mortgage bonds, which brings me to the next impact of a rising interest rate environment.

2. The housing market will weaken

Most houses are purchased using debt: Buyers put a small amount of money down and they then take out a mortgage to pay for the rest. As interest rates rise, mortgage payments on new and adjustable loans will increase. In the first case, this means that an individual who can afford, say, a $300,000 house with current rates might only be able to afford a $250,000 house at a higher rate and a still lower-valued house if rates continue to rise.

This will put pressure on home prices. In the second case, if mortgage payments rise for people with adjustable rate mortgages, they will either be foreclosed upon or they will have less disposable income. The former hurts the housing market and the latter hurts retail sales, especially for discretionary items.

3. The stock market will weaken

The same argument that I made regarding bonds applies to stocks insofar as stocks are cash flow yielding assets not unlike bonds. Just like a bond has a yield, a stock has an earnings yield, which is the inverse of its price-to-earnings multiple. If bond prices rise, then the value of stocks on an earnings yield basis will come down to reflect the fact that interest rates, and therefore earnings yields, must rise.

For instance, a stock that trades at 20 times earnings has a 5 percent earnings yield. If interest rates rise by 1 percent and this stock’s valuation falls to reflect this, then it needs to fall so that its earnings yield is 6 percent. This would give it a price-to-earnings multiple of 16.7. If the company can generate more earnings then it might not necessarily fall, but it won’t rise as much as it would have in a flat- to lower-interest rate scenario.

In short, a rising interest rate environment would be negative for many financial assets. As a result, investors who are concerned that interest rates will rise should be careful in choosing which stocks and bonds to own. You should carefully watch the TLT for any further weakness. You should also watch its cousin, the iShares Barclays 1-3 Year Treasury Bond ETF (NYSEARCA:SHY), in order to get a read on shorter-term interest rates.

Disclosure: Ben Kramer-Miller has no position in the ETFs mentioned in this article.

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