The sharp rise in U.S. interest rates has heckled the equity markets at the beginning of the year, and the evolution of rates will also be crucial for ETF investors over the medium term. Even passive investors, unless they have a fully systematic investment plan, need to avoid bad entry points into the markets, especially before a sharp rise in interest rates.
In addition to the decline in demand for government bonds, which is part of the reason for the rise in interest rates, two other factors have been cited. First, the rise in interest rates is likely to be a consequence of the very loose fiscal policy of the U.S. government under new President Joe Biden. In the coming months, even more bonds will need to be placed with investors when the supply of these government bonds has already increased. The many new securities have already tested the limits of the absorptive capacity of the bond markets in the United States, but also globally. Second, investor expectations that inflation could rise and accelerate significantly are also pushing dollar rates higher. The shutdowns of some economic capacities caused by the virus have disrupted some production and supply. These problems, if widespread, could lead to higher prices.
A rise in interest rates not only leads to price declines in bonds, but can also strongly impact equities for the two main reasons below:
1) a higher bond yield makes bonds more attractive relative to more volatile stocks. A real rate of return of 2% already could reduce the attractiveness of equities as an asset class to offset low rates and investors could start to shift their funds from dividend paying securities to interest paying securities. At 3% this risk would become very real, especially for investors who today see equities as a substitute for bonds in order to provide a minimum return.
2) On the other hand, interest rates also reduce valuations. When future earnings are calculated on the basis of higher reference rates, the value to date is depreciated du to a higher discount rate. Some valuations are only justified by such low interest rates and an increase would cause the present value to fall.
While few market professionals expect a drastic decline in the stock market, a rise in interest rates could easily cause a 10% correction. So keep investing, but do it carefully!