The sharp rise in US long-term bond rates is the biggest risk facing the stock market right now. The 10-year bond rate has increased to 4.85 percent, the highest since 2007.
Rising rates have several negative repercussions:
1. The most obvious of which is the higher risk of default and weaker economic growth. It discourages consumers and businesses from borrowing and spending, while borrowers will have to pay a higher cost of debt. Higher rates also have a negative impact on economic growth, specifically an increased risk of recession in the US.
2. Lower stock prices. Analysts use longer-term bond rates in valuing stocks. As the 10-year bond rate goes up, the present value of future earnings goes down, leading to lower stock values. Moreover, the prices of stocks must go down to improve their competitiveness against bonds that now provide much higher yields.
3. Higher rates are led by longer-term bonds. The increase in bond rates the past few months was led by longer term bonds. While the 2-year bond rate is up by 31 basis points since the end of June, the 10-year is up by 101 basis points and the 30-year, 106 basis points.
4. Significant decline in bond values. The price of bonds is inversely related to interest rates (higher interest rates mean lower bond prices). Consequently, the recent increase in interest rates would lead to significant losses for bond investors, especially those who bought large amounts of longer-term bonds thinking that interest rates would stay low.
5. Possible margin call. Because of the steep rise in bond rates, funds employing leveraged strategies could suffer from a margin call. When this happens, funds will have no choice but to indiscriminately sell bonds in their portfolios. It’s a vicious cycle of forced liquidations, higher bond rates, bond price decline and more selling from funds suffering from margin calls.
6. Harbinger of an upcoming recession and bear market in stocks? In 2001 and 2007, longer-term bond rates increased after the yield curve was initially inverted. These were shortly followed by a recession and a bear market. Some analysts are worried that the developments, alongside the steep yield curve, are warning signs of a fast-approaching recession and bear market in the US.
If the US enters a bear market, Philippine stocks could also go down. The Philippines has always suffered from a contagion during past bear markets.
Given the numerous risks facing equity markets, there is a greater chance that local stocks will remain weak in the short term. As such, it would be wise to maintain some cash and stay underweight in stocks.
However, it would also be wise to prepare mentally to deploy that extra cash if local stocks are sold off due to a contagion triggered by a US recession and a steep decline in the S&P 500.
As I’ve discussed in my previous columns, the Philippine market is already in a no-interest phase, which is characterized by low trading volumes and ridiculously cheap valuations.
Because of this, those who have a longer investment time horizon can take advantage of the opportunity to buy stocks at very cheap prices.
The main drawback of buying stocks during the no-interest phase is that it can last for a very long time. Make sure to use only funds you are sure you will not need in the near term. Also, focus on blue chips that pay cash dividends so that you are paid to wait. Most importantly, constantly remind yourself that your patience will be significantly rewarded when the Philippines finally enters a bull market. INQ