A rise in interest rates on Treasury Bonds and the effect on the average price of a company’s common stock
April 29, 2009 by How Savings Bonds Work
Filed under More Bonds Answers
Can you answer sb’s question about Bonds?:
Suppose interest rates on Treasury bonds rose from 5 to 9 % as a result of higher interest rates in Europe. What effect would this have on the price of an average company’s common stock and why?
Tax Free Government Bonds
Suppose interest rates on Treasury bonds rose from 5 to 9 % as a result of higher interest rates in Europe. What effect would this have on the price of an average company’s common stock and why?
Tax Free Government Bonds
Bonds Feedback: Five reasons for a harmful effect.
1) Any short term debt would be more costly to them.
2) Any (proposed ) long term borrowing would be more costly.
3) Customers would cut back on new purchases.
4) The company may not be able to up-grade its equipment because of increased costs all along the line.
5) The stock markets would reflect increased uncertainty.
Bonds Feedback: The United States of America cannot rise interest rates to 9%
They already have debts for 64.7% of the GDP.
A rise like that would increase debt to over 100% of the GDP and the economy would slow to 0%
Every public company in the United States of America would borrow money in Euros, Yens, Yuans, British Pounds, Canadian Dollars, Reals, Wons, Rupees and Mexican Pesos and the banks based on the United States of America will lose money and that would crash the stock market.
RECIPE FOR DISASTER
Bonds Feedback: The short answer is it can be very bad.
Assuming you have a finance background, the value of company is determined by the value of its discount cash flow. The higher the interest way, the higher the discount rate one needs to use to value the cash flow of a company i.e. the lower is the NPV of the value of a company.
Put it another way, a rising interest rate environment can be very bad for companies because: a) consumers have less money to spend because they need to set aside more money for their mortgages/borrowings, b) it becomes more expensive for companies to expand if they need to borrow from the banks, c) if an investor can suddenly make 9% risk free by putting money with a bank, the company needs to be valued more attractively to make it a worthwhile investment e.g. the company may need to offer a higher dividend…
The bottom line is a 9% interest rate environment would distort the relative merits of various asset classes. Going from 5% to 9% implies a very sharp correction….
Bonds Feedback: I’m sorry frank, but you’re way off. The U.S. can’t raise rates to 9%? The U.S. is in a position where she would have to raise rates. The dollar has been in freefall from 2001 and is on the verge of a collapse. Why do you think Volker raised rates to double digits in the 70’s? Because the dollar was in major trouble and to prop up the dollar, the fed raised rates to almost 20% to prevent a dollar crisis. And in the 70’s the U.S. was a creditor nation. Today, the U.S. is the world’s largest debtor nation. To prop up the dollar and keep the trillions of dollars that foreigners invest in U.S. assets, the fed would by default have to raise rates as the dollar falls in value. Frank, you really need to stop answering these questions if you don’t know what you’re talking about. I have seen on multiple occasions you giving answers that are completely erroneous.
The first poster is correct in that higher rates would make borrowing costs for corporations higher, thus affecting their bottom line which in turn would cause stock valuations to drop. In addition, consumers would spend less as the majority of American consumers spend out of debt and not savings and income. For example, according the the BLS (Bureau of Labor Statistics), the average American is making the same amount of money today as they did in 1972 based on inflation adjusted wages and costs; 70% of GDP is consumer spending and if real wages (inflation adjusted) have been stagnant or falling for the last 30 years, then how have American’s been spending? The savings rate in the U.S. is negative. They way they’ve been spending is via debt, ie, credit cards, equity withdrawals from their homes, etc. As rates go up, borrowing costs are going to increase thus prompting higher debt service payments. As consumers can not afford high debt service payments, spending would be curtailed thus, less sales revenue to companies, thus driving down their bottomline and driving down stock prices.
Don’t listen to Frank. The fed right now is in a pickle of a situation. Inflation is still a primary concern, that’s why the BoE and ECB have raised rates (as well as the majority of world Central Banks). But for the U.S., it’s worse. When the stock bubble popped in 2000, to prevent an economic contraction, the Fed lowered interest rates to 1%. They succeeded, but instead of money flowing back into stocks, in flowed into real estate. That’s why real estate took off in the last 5 years. But, at the same time, the dollar went into freefall. As the fed began raising rates again, the dollar stabilized. But, that started to put pressure on the real estate market as raising rates made it more expensive to purchase real estate. And the real estate bubble is what propped up the U.S. economy in the last 5-6 years.
But, the world is losing confidence in the dollar as the U.S. runs huge current, budget and trade deficits. Many countries are diversifying out of dollars, that’s what the dollar headed south again in the past several months. So, what is the fed to do? If they raise rates to prop up the dollar, they’ll kill the housing market. If they lower rates to save the housing market, that would be the death knell for the dollar and we’d, in short order, experience a dollar collapse. In my opinion, a dollar crisis would be vastly more devastating then a real estate collapse. If the fed moved to prop up the dollar during a dollar crisis, it would mean interest rate hikes of 4, 5 or 6 percent or more, not just 25 basis points. Remember, in the 70’s to prop up the dollar, Volker raised rates to near 20%, and the U.S. was in much better shape then than it is now. A dollar crisis now could very realistically prompt the fed to raise rates well above 20% to stave off a severe dollar rout.
In a nutshell, higher rates translates to lower common stock prices.