Interest Rates, Bonds and Stocks: the yield curve

by George Hatjoullis

Some time next month it is likely stock markets will correct lower. They often do at the start of the summer. This time we may also have the added influence of a sovereign debt default by Greece and the prospect of an interest rate increase by the Federal Reserve, quite possibly quickly followed by the Bank of England. Equity markets seem unmoved. They continue to push up despite being near the top of any technical boundaries one might use. This is quite odd. Equity markets are forward-looking and they seem not to see any of this or believe it unimportant. Indeed, both the Federal Reserve and the Bank of England have openly criticised the ‘markets’ for being overly optimistic about the path of interest rates. These two central banks, which after all have the power to set short-term interest rates, are telling markets that interest rates will rise faster and higher than the ‘markets’ are pricing. This is odd.

The ‘markets’ that price implied forward interest rates are not equity markets as such but the bond markets, but they all join up. At any point there is a market or spot yield curve. This is implied by actual risk free government bond prices and corresponds to a series of yields for each zero coupon bond (often notional) maturity. A zero coupon bond is just a bond that pays a value (usually 100) at maturity and no regular coupon or interest. From this yield curve it is possible to calculate implied forward interest rates, e.g. the 3 month interest rates every 3 months forward (anyone interested in the calculations should see my Personal Finance series of blogs). So, when the Fed says the market is too optimistic, it means that the spot or current yield curve is too flat e.g. the difference between 2 year interest rates and 30 year interest rates should be greater. So what will happen when the Fed starts to raise interest rates?

The market knows that the interest rate increase is inevitable and coming soon (if they do not then perhaps i should come out of retirement!). Unless the interest rate increase is accompanied by some material new information, then logically the market will not respond much. The yield curve will simply flatten further as short-term rates rise but longer maturity rates rise less than in proportion. The assumption that is often heard in the press, that the first interest rate increase will cause sell off in the bond markets, does not follow automatically. The sell off may be quite muted and short-lived. In economic terms this will be the market telling the Fed that he economy remains fragile and even a small rise in rates will choke off growth and any incipient rise in inflation. Of course, time will tell and we shall see but bear in mind that yield curves can change shape quite dramatically.

This may also explain why the equity markets have become complacent. If the yield curve is expected to flatten then the valuation effect of an interest rate increase is muted because the discount rate, typically a long-term interest rate, does not increase very much and is not expected to increase for very long. The key response that all should focus on after the first interest rate increase is how the yield curve, and hence implied forward interest rates, behaves. If it flattens then any equity market sell off will most likely be corrective, shallow and short-lived. If the yield curve steepens then a much deeper correction may be in the cards.