Weekly Charts
Each Thursday, the MCP Research team will share two charts we’re currently looking at that bring insights into the current state of the markets. This week—interest rates.
In general, interest rates have a straightforward relationship with equities. Higher interest rates means lower prices, and lower interest rates means higher prices. When we dig deeper though, we can find that different interest rates will have different effects on various equity factors.
In Figure 1, we can see the relationship between the 10Y Breakeven rate and value stocks. The 10Y Breakeven is an inflation expectation proxy, we can interpret this rate as the return on a cash deposit needed to maintain purchasing power over a 10Y period. Since a higher Breakeven implies higher short-term returns on cash, investors would prefer to hold assets that have higher immediate returns on capital, like value stocks.
While value stocks are tied to inflation expectations, Figure 2 shows a different relationship for growth stocks. Given the long duration, minimal cash flow properties of growth stocks, rising rates and inflation is not necessarily a bullish driver. In fact, these stocks tend to perform better under deflationary environments, when investors are forced to look for returns far into the future to avoid short-term capital destruction. Thus, the Nasdaq has been highly correlated with the inverse in real interest rates, we can think of the real interest rate, as the gain/loss in purchasing power we’d receive over a 10Y period if we were to buy a bond at today’s rates. When real rates fall (capital destruction), growth stocks are favored. Currently, real rates are at -0.9% and have recently been trading lower.
2021 will prove to be a battle between these two diverging rates. Breakeven rates and inflation expectations are especially difficult for the Federal Reserve to control. They’ve been largely driven higher by soaring commodity prices, global stimulus, and the post-COVID reopening. The Federal Reserve does, however, have control over real interest rates through the purchase of TIPS bonds, which they have buying in large quantities through their QE programs. Over the past two months, Breakevens have soared, and real rates have tanked – unfortunately, one of these narratives has to cave to the other, at which point either growth or value investors will be left to dry.
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