Options Theory: How Interest Rates Impact Stocks
September 24, 2021
You know by now that the stock market recovered after this week’s Federal Reserve meeting. But did you also know that interest rates jumped? Wall Street’s go-to gauge for tracking rates is the ten-year treasury yield. It measures the interest rate on U.S. Treasury Bonds with a maturity of ten years. In theory, it’s supposed to rise and fall with inflation expectations as well as forecasts for the future path of the Fed Funds rate.
You can chart the ten-year yield in ThinkorSwim using the ticker “TNX.” Note the ascending triangle pattern that just broke out.
As a reminder, bond yields and bond prices move in opposite directions. So while TNX is popping, bond ETFs like TLT, IEF, and like have been puking. You can learn more about the bond market in these blogs.
So what’s the implication for stocks? Well, some sectors are more sensitive to interest rates than others. Rising rates help some industries while hurting others. Here’s an insightful graphic that shows this:
Let me break it down for you. Each bar represents a different industry. The right half of the graph show areas that benefit from rising rates. The left half reveals areas that suffer from rising rates. Which two sectors are most represented on the right side?
Energy and Financials
These more than any receive a tailwind when rates are rising. The rationale for banks being helped is pretty simple. Rising rates increase their profit margins.
Explaining the boon to energy is also relatively simple. Rising rates are usually a byproduct of inflation. Crude oil is sensitive to inflation, indeed it is one of the go-to commodity prices that traders use as an inflation gauge. And, as goes crude oil, so goes the energy sector.
Most all sectors rallied in the wake of the Fed meeting, but do you know who rallied the most? Energy (XLE) and Financials (XLF). The market doesn’t always make sense. This is a week where price movements made a great deal of sense.
How about the left edge of the chart. REITs (XLRE) and Utilities (XLU) are most hurt by rising rates. Why?
First, because they’re both viewed as bond proxies. When interest rates are low, investors flee to the higher dividend yields of utilities and REITs. And then, as interest rates rise, the flow reverses. That is, the higher interest rate of bonds starts to look more attractive to income seekers.
Second, real estate and utilities are heavily financed by debt. Falling rates make it cheaper to operate. Rising rates make it more expensive. This filters through to their profitability.
Class dismissed.
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Great lesson. Thank you very much, coach Tyler!