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How Interest Rates Affect Stock and Bond Prices

A reader writes in, asking:

“I’m aware that bond prices and bond interest rates have a high correlation with prices typically going down when rates go up. What happens to stock prices if rates go up? Is that something I should be afraid of?”

To back up a step, bond prices and bond yields aren’t just closely correlated. They’re directly mathematically connected. A bond’s current yield is calculated by dividing the interest it pays by its current price. If the price goes up, the yield, by definition, goes down. If the price goes down, the yield goes up. No exceptions. (Think of two opposite sides of a seesaw.)*

This is a crucial point, so please forgive me for belaboring it: Saying that bond rates went up is simply another way of saying that bond prices went down.

Interest Rates and Stock Prices

The connection between interest rates and stock prices, however, is not nearly as reliable.

If interest rates go up, all else being equal, stock prices will go down — because some investors will choose to move their money from stocks to bonds, given that bond yields have become more attractive than they used to be. (And this reduced demand for stocks will cause stock prices to decline.) And conversely, if interest rates go down, all else being equal, stock prices will go up — because some investors will choose to sell their (now lower-yielding) bonds in order to move to stocks.

The catch, of course, is this “all else being equal” business. In the real world, there are thousands of other variables, and they’re always moving around.

So, for instance, if interest rates go up, how stock prices will actually react depends on why interest rates went up. That is, what changed in our economy to cause lenders to raise their rates? And how does that change affect our expectations for corporate earnings? If the change has a positive effect on corporate earnings expectations, stock prices could very well go up in spite of interest rates going up. Conversely, if the change has a negative effect on corporate earnings expectations, stock prices will go down, and they’ll go down by more than the amount that would be predicted solely by the change in interest rates.

*Update: Boglehead Taylor Larimore astutely points out that there is in fact an exception: cases in which the actual terms of the bond change (i.e., bankruptcy). If a bond is discharged in bankruptcy, its price and yield would both fall at the same time (to zero). As long as the terms of the bond do not change, however, the inverse relationship between price and yield cannot be violated.

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