Interest rates have over the last couple of days started to sharply trend upwards. As a result equity markets, both in the US and around the world have turned downwards. The market is expecting the US federal reserve to make further rate increases both this year and 2019.  Investors are shifting their capital from equites and international markets to US government bonds as the return differential between the asset classes decreases. In other words, investors are getting relative higher yields on safe US government bonds, compared to more risk equity investments. There is a possibility the equity markets could continue its decline if investors believe in even faster rate in the interest rate hikes.    

In the last couple of days we have seen interest rates (for example 10-year government bonds) trend higher. These increases are on back of the Federal Reserve raising its benchmark rate for a third time this year. In addition, the markets are expecting further rate increases both this year and 2019.

As a quick primer, when the Federal Reserve raises its benchmark rates, it makes it more expensive from various banks to borrow from the Fed. When this happens, banks and other financial institutions subsequently raise rates on mortgages, credit cards and other types of loans they offer. As a consequence of higher rates, the consumer will have less discretionary money to spend. Same principle applies to businesses as they have to pay higher interest-rates on their loans, meaning the businesses become less profitable.

When government bond yields increase, they become more desirable for an investor as they will receive higher yields (“returns”). As most investors are looking for best returns, a higher “risk-free” return on government bonds can lead to investors selling their stocks and buying government bonds.

All of this means that there tends to be an inverse relation between interest rate levels and the stock market. When rates are low (as they have been last 10 years or so), one receives relatively higher risk-adjusted returns from equities. As rates start to increase there will come a point where more and more investors look at the bond market.

Below is 5-year chart of the 10 year treasury bonds. It is now at its highest level during the last 5 years, at 3.23%. Investors are taking notice.

Source: Bloomberg

Investors believe that the Federal Reserve potentially will make additional rate increases. A tight labor market (see Amazon minimum wage increase to $15/h as an example), leading to higher wages, results in further pressure on the Federal Reserve to raise rates. Fed president Powell confirmed this last week;

Powell on Wednesday said that the Fed had a long way to go before interest rates would hit neutral, suggesting to markets that more hikes could be coming.

With continued possibility of rate increases around the corner, yields rising sharply the last couple of days, equity markets are taking a hit. S&P500 (SPY US) index is down almost 2.5% of the last 5 days.

Source: Bloomberg

Usually the stock sectors mostly hit by rate increases are sectors the most affected by higher rates. Homebuilder stocks (XHB US) tend to have a negative correlation with rates. As rates go up, mortgages will become more expensive and consumers are less inclined to buy real-estate.  The utility sector (XLU US) is another sector negatively affected. Investors usually own utilities for their dividend yields. If rates on government bonds increases, the utility sectors dividend yields will become less attractive.

Finally, emerging markets (EEM US), tend to take a substantial hit when rates increase. As rates in the US increase, investors will put more money in US government bonds. First this means, investors are pulling money out of rest of the world.  Secondly, as investors shift their capital to the US, the US dollar will strengthen. As a results of USD strengthening, the premium of risk-reward to be invested in emerging markets declines.

Finally, these correlations are not 100% at all times. Various other factors, such as macro, trade, and geopolitical affect both the bond and equity markets. Sometimes equity markets could actually increase in a rising rate environment (as investors want inflation hedges). Sometimes there might not be a reaction in any form. All in all, most of times when there is change in rate environment the markets movements (volatility) tend to increase.