Revisit: How interest rate affects the market - a mathematical courtship

[First published on 13/10/2018]

What would happen when the banks increase their interest rate? Here's a simplified theoretical summary of the relationship between interest rate and securities.

• When interest rate rises, people will start to park more of their money in the bank and government bonds (which is assumed to be risk-free). Therefore stocks or higher risk instrument prices will start to decline. However, in view of economic recovery, it will take some time before a bear market sets in? https://www.valuewalk.com/2015/06/will-rising-interest-rates-murder-the-stock-market/
  
  That is also what we are seeing in 2021, as growth stocks lose their shine given their high valuations. https://www.cnbc.com/2021/03/12/the-fed-could-be-a-catalyst-for-bonds-and-that-could-drive-growth-stocks-in-week-ahead.html

• REITS might be adversely affected due to the increase in their debt's interest (so they either have a higher sum to repay as a result or may cut down on borrowing for expansion). That's why we always talk about NAV and gearing ratio when we look at REITs. On the bright side for those looking to get in cheap, REIT yield would increase when their share prices drop.
  
  To learn more about REITS, I would recommend these 2 blog posts by namely Heartlandboy and Financial Horse:
  How to understand REIT jargon when investing in Singapore REITS
  5 things to look out for when investing in REITs

• Retail bond prices would decrease, because again more people will choose to park money in the bank or government bond. Bond yields of new bonds issued would increase to compensate as a result.
  
  However, given that the interest rate in SG is still... low as ever, that's why we are seeing Astrea VI bond issuing at a paltry 3%. Personally I would not be subscribing to it as it means locking up my money from stocks market opportunity.
  
  
• Gold would also lose its shine as it is a no-income generating asset. It makes more sense for people again to park their money at the bank or government bond to generate interest income in a rising interest rate environment.

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Conversely, in bad economy, governments would lower interest rates to help stimulate the market, aka being Dovish. [Difference between Hawkish and Dovish.] So a falling interest rate would typically cause the market to change from bearish to bullish. Borrowing cost for companies would be lowered in a low interest-rate environment and companies could then use the borrowed money to grow their businesses. When earnings improved, it would drive up the market. It's slow multi-year transition from bad economy to good economy then back again. Nevertheless, I think many of us would have experienced the cycle at least once in our life.


With that, we have a rough idea of how the money flows and why re-balancing of portfolio allocation in a cycle might make sense.


Related readings:

https://rainbowcoin.blogspot.com/2020/03/the-irrational-market.html

https://www.sgmoneymatters.com/rising-interest-rates-stock-market-impact/

https://www.bloomberg.com/news/articles/2018-10-11/wall-street-sees-treasuries-yield-curve-flattening-into-2019

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Interest rate above I am referring to the nominal interest rate. Note:

Real interest rate = Nominal interest rate - inflation rate

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