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Implications of Rising Interest Rates
Financial Markets
Implications of Rising Interest Rates
  • By matthew
  • July 19, 2013, 08:42
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The yield on three-year Korean government bonds, which fell to 2.44% in early May, has risen to back above 3%. The yield on 10-year US Treasuries surged from 1.62% in early May to 2.54% in June. 

Is this upswing of interest rates positive for the economy and financial markets?

The answer is “It depends.” Actually, it depends on key drivers behind the rise in interest rates.

Daniel Cho, CFA, is Head of Research at Daishin Securities in Korea.Different risk factors weigh on different crises. In the late 1990s, global economic and financial risk factors sent interest rates higher, such as during the Asian economic crisis (credit risk). In the summer of 2008, oil prices surpassed $140, setting the stage for a global financial crisis (inflationary risk). Fast forward to June 2013, markets are in the grip of fear over US QE tapering (liquidity contraction risk). The risk-induced rise in interest rates increases the financial burden on companies, especially those with low credit ratings, and that is reflected in stock markets. 

In contrast, the interest rate spikes in the first half of 2009 and during the three-year period from 2005 to 2007 were driven more by economic recovery expectations. When economic fundamentals improve, money demand rises, causing interest rates to climb. In such a scenario, economic growth will follow. If this occurs, higher interest rates are good for the share prices of materials and industrial stocks that are heavily exposed to bank loans. Positive effects from increasing demand more than offset any negative effects from higher interest expenses when there is an economic recovery. Financial institutions’ earnings also improve when interest rates rise. 

Different asset markets move differently, depending on the main drivers of higher interest rates, which send two conflicting messages. Higher interest rates reflecting increased risks push down stock markets, whereas higher interest rates reflecting positive economic expectations push up stock markets in a rotation from bonds (safe assets) to stocks (risk assets).

The biggest factor behind the ongoing global market correction is US QE tapering worries. All other factors (Abenomics volatility, China’s credit crunch, and Europe’s problems) are only secondary factors. We believe the current stock market correction is temporary. Investor confidence in the strength of a real economic recovery is shaky, and worries linger regarding a pullback of liquidity that has been shoring up investor expectations for so long. However, stock markets will overcome this wall of worry over time. 

US economic fundamentals are recovering to the extent that QE is necessary (the same level before the September 2008 Lehman Brothers collapse). For instance, as recently as April 2013, average US home sales prices, an indicator of consumer buying power, were higher than in September 2008. The US economy is recovering to a point where QE is no longer needed. US economic fundamentals are stronger than they were when QE1 and QE2 ended. Investors will gradually regain optimism regarding economic recovery, finding evidence of a sustainable US economic recovery in housing prices, employment, and consumption data. 

Meanwhile, the Korean economy will take an upturn in the second half, with GDP growing more than 3%. Its 2Q13 GDP growth, to be released in late July, will show a Korean economy bottom outing, adding fuel to positive expectations. 

Our view of interest rate movements and economic data is that as of June, economic recovery expectations explain only 13% of the rise in US interest rates, while QE tapering accounts for the remaining 87%. In Korea, dividend stocks are holding their ground in spite of rising bond yields, another indicator that risk factors are still driving the rise in interest rate. 

The main catalyst of higher interest rates will gradually switch toward economic recovery expectations.. Domestic institutions have no choice but to increase exposure to risk assets even in the absence of strong confidence in the economy’s recovery. Having reaped handsome gains from bonds over the past four years, high net worth individuals will look for higher returns in equities. As a result, funds will flow back into Korean stocks in the second half.