Investor Handbook: Why Lower Interest Rates Are Good for Stocks

Source: Thinkstock

Source: Thinkstock

Investors often mistakenly believe that bonds and stocks trade inversely to one another. Bonds, particularly Treasury Bonds, have been called “safe haven” assets, and we have seen recently that when stock prices have weakened, Treasury Bond prices have strengthened. But this short-term negative correlation is misleading. Bonds and stocks often trade together in the longer term. For instance, both stocks and bonds were in a bear market in the 1970s and they entered a bull market in the early 1980s simultaneously.

There are good reasons that investors should expect a correlation between bonds and stocks. For starters, investors value stocks based on the return that they can get by owning them. This return is often measured by a company’s earnings, and a stock is valued based on its price relative to these earnings. If bond prices rise and interest rates fall then investors, who are getting a lower return in the bond market, will come to accept lower returns in the stock market. Similarly, if bond prices fall, stocks become less enticing as investors can get similar returns in bonds without the risk that comes with stock ownership (e.g. earnings fluctuation.)

Second, in a low interest rate environment not only are stocks inherently worth more in relation to bonds, but companies are more valuable insofar as they can borrow money at a lower rate. When bond prices rise and interest rates fall this usually takes place across the entire bond market. Thus, companies who can access the debt markets can borrow at a lower rate when bond prices are low. This gives these companies more money with which to invest.