There’s no question that interest rates are on the rise. The yield on the 30-year Treasury bond sank to 2.1% in early July … but just hit a four-month high of 2.49%. As for the shorter-term 5-year Treasury, its yield rose from around 0.91% to 1.3% during that same time.
But is that bullish for stocks? Or bearish? One of my Safe Money Report subscribers asked that question the other day, so here’s my take: It depends.
Specifically, it depends on how rates rise, which rates rise, and which kinds of stocks you’re talking about.
For example, if longer-term rates rise, it should hurt Real Estate Investment Trusts (REITs) and utilities.
That’s because rising rates aren’t just bad for bond prices. They’re also negative for the price of “bond-like” stocks, and those sectors fit the bill. Given the massive overvaluation we’re seeing in commercial real estate and many REITs, the damage there could be particularly severe.
Banks and insurance companies should theoretically benefit from rising rates because they would allow them to charge higher rates on loans, and invest spare funds at higher yields. But it really depends on how the relationship of various rates changes as rates go up.
For instance, if all rates go up, but short-term rates rise faster than long-term rates, that’s actually bad for many financial stocks.
The reason? The yields they pay out to depositors and lenders rise faster than the yields they earn on loans and investments. That puts the squeeze on something called “Net Interest Margin,” a key bank profit margin.
Here’s something else to think about: Rising rates typically go hand in hand with an improving economy. So you could make a case that’s bullish for sales, earnings, and stock prices.
But the era of ultra-low interest rates has juiced stock valuations substantially. The semi-wonkish explanation? Stocks are priced (theoretically) by estimating future cash flows, then discounting those flows back to the present using a given discount rate.
Lower rates push the discount rate down. That, in turn, drives asset prices up. Higher rates do the opposite. So if we do get a sharp rise in rates, overvalued stocks could come under pressure.
Bottom line? Things aren’t as clear cut now as they’ve been in the past. So my recommendations are to:
- Reduce the interest rate sensitivity of your portfolio by sticking with shorter-term Treasuries or bond funds. Look for key measures of interest rate risk, such as average duration or average maturity, in your ETF or fund literature. The lower those numbers, the less value your fixed-income investments will lose if rates rise.
- For stocks, favor select investments in sectors like technology, health care, and consumer staples. Reduce your exposure to highly rate-sensitive names, but don’t just sell everything as there are some higher-yielding stocks I still like.
- Want more specifics? Then check out my Safe Money Report, where I give my current recommendations as well as specific “buy” and “sell” instructions.
Until next time,
Mike Larson is a Senior Analyst for Weiss Research, and is also the creator of the course “How to Profit From Rising Interest Rates”. A graduate of Boston University, Mike Larson formerly worked at Bankrate.com and Bloomberg News, and is regularly featured on CNBC, CNN, Fox Business News and Bloomberg Television as well as many national radio programs. Due to the astonishing accuracy of his forecasts and warnings, Mike Larson is often quoted by the Washington Post, Chicago Tribune, Associated Press, Reuters, CNNMoney and many others.