How do real interest rates affect the stock market?
Interest rates are historically known to move in the same direction as inflation, because the central bank uses the interest rate as its primary tool to control inflation.
When prices are rising and consumer spending is growing, the central bank can try to slow down the rate of increase in prices, or inflation, by raising interest rates.
Conversely, when inflation is falling and the economy is slowing, the central bank can try to stimulate demand and increase price levels by lowering interest rates.
In 1930, an American economist by the name of Irving Fisher suggested that the interest rate can be defined as the sum of real interest rate and inflation rate.
Fisher argued that by keeping real interest rate constant, the movements of interest rates can be anticipated by estimating the changes in expected inflation.
For example, if the current 90-day T-bill rate is 1.428 percent and inflation is 3 percent, we can compute the real interest rate by deducting the inflation from the T-bill rate to derive a -1.57 percent.
By assuming the real interest rate to be constant, which in this case is the -1.57 percent, a 1-percent increase in inflation from 3 to 4 percent should theoretically increase the T-bill rate to 2.428 percent.
The negative real interest rate of 1.57 percent means that if you put your money in T-bill today that pays you 1.428 percent, the interest that you will earn from it will not be enough to compensate you for the loss in purchasing power of 3.0 percent, making you lose by 1.57 percent in real value.
In reality, if we look at the historical inflation and interest rates for the past 20 years, we will find that the real interest rate was never constant as assumed by Fisher, and the impact of the increase in inflation on interest rate was rarely point-for-point.
In fact, the real interest rate of the 90-day T-bill has been trending downward from a high of 7.0 percent in 2000 to a low of -2.4 percent today.
Because negative real interest rates discourage savings, we can find that during this period when real interest rate was falling, the excess liquidity flowed into the stock market, which drove share prices to go up.
This strong negative correlation between the real interest rate of 90-day T-bill and the Philippine Stock Exchange (PSE) index was particularly evident when the real interest rate was negative.
When the stock market was in 10-year bull run from 2008 to 2018, the real interest rate of the 90-day T-bill has averaged at -1.3 percent.
And when the real interest rate increased to 1.9 percent in 2019, the PSE index fell from a high of 8,419 to a record low of 4,039 during the early part of 2020 pandemic.
The economic downturn in 2020 prompted the central bank to cut its interest rates, which saw real interest rates falling again into the negative territory.
As expected, the fall in the average negative real interest rates, from -0.5 percent in 2020 to -2.8 percent last year fueled the recovery of the PSE index from its historic low in 2020 to the present.
The return to economic normalcy this year has raised fears of escalating inflation. Interest rates have been rising steadily to prepandemic levels in anticipation of higher inflation rates.
For example, the 90-day T-bill rate has been going up from 0.718 percent at the start of the year to a high of 1.55 percent in March.
This increase has raised the real interest rate of the T-bill from -2.8 percent in 2021 to -1.57 percent today.
If this trend will continue, we may see real interest rates regressing to its recent high in 2019 at 2.5 percent, which may mean higher nominal rates.
The increase in interest rates also mirrored the rise in the 10-year Philippine bond yield, which has risen from 4.7 percent in January to 6.16 percent last week.
Recent surge in interest rates tells us not only risks of rising inflation but also risks of higher real interest rates in the coming weeks, which could add pressure for the stock market to fall. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 95th batch of RFP program this May 2022. To register, email [email protected] or text at 0917-6248110
