If you’re thinking of investing in stocks (or bonds) because you can’t think of anywhere better to put your money, you might want to take a pause and ponder what Stanley Fischer, the vice chairman of the Federal Reserve, just said at a conference in Tel Aviv, Israel.
Fischer, speaking this week, said the Fed expects to raise short-term interest rates from its current 0% to around 3.25% to 4% within the next three or four years.
That was not his personal guess, he said, but the central target being used by the economists at the Federal Reserve.
Three-and-a-quarter to 4%. Compared with 0% today.
If short rates go there, then history says the 10-year Treasury bond rate TMUBMUSD10Y, -0.49% may rise from today’s 2% to about 4.25% to 5%.
And from those two simple things, a gigantic chain of dominoes all across the stock market — and the world, for that matter — will start to fall.
Raising the interest rate on 10-year Treasury bonds from today’s 2% to 4% — in line with Fed expectations — would halve the present value of the stock market.
No one will want to buy a 2% Treasury bond when they can buy a 4% or 5% Treasury bond. So the Treasuries you own will get marked down, massively, to compete.
No one will want a 5% corporate bond with a risk of default when they can buy a 5% Treasury bond with no such risk. History says that, in order to compensate for their risks, corporate bonds will have to yield considerably more than equivalent Treasuries to compete — so they, too, will be marked down sharply.
Bad news for your bond funds.
And then we come to stocks.
How easy it is to forget, amid the news and noise of corporate earnings, buybacks and sundry other deals, that half of the value of the stock market has nothing do to with what companies or stocks are doing.
Half the value of the stock market lies, instead, in the so-called “cost of capital” — in other words, the rate of interest you could earn by ignoring stocks and sticking your money somewhere else.
So when the interest rate on Treasury bonds rises, stocks become a lot less attractive by comparison.
Their price has to fall in order to keep the same relative appeal. That is simple mathematics.
Based on the standard financial model used on Wall Street, raising the interest rate on 10-year Treasury bonds from today’s 2% to 4% — in line with Fed expectations — would halve the present value of the stock market.
That, I hasten to add, is neither a forecast nor a guesstimate nor really an opinion. It is simply what happens when you take the predictions offered by the vice chairman of the Federal Reserve and plug them into Wall Street’s standard model for valuing stocks.
Make of it what you will. School will soon be out for the summer. But mathematics, I’m afraid, never takes a vacation.
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