The Independent Market Observer

6/13/13 – Price Discovery and Stock Market Volatility

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 13, 2013 10:52:50 AM

and tagged Market Updates

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Yesterday, I wrote that rising interest rates are the result of investors trying to discover what the real, market-set interest rate levels might be once the Fed starts pulling back from its stimulus program. Rate-setting by the Fed will be replaced by rates set by the market—and no one knows what they will look like.

What we do know is that rates will be higher. After all, if you remove a significant buyer from the market, demand will go down and so will prices. Lower prices for bonds will mean higher interest rates. What no one knows is exactly how much higher.

There are reasons to believe the change might be relatively small. Interest rates in Germany and other high-credit-quality countries have remained at very low levels, and S&P’s recent decision to upgrade the outlook for U.S. credit suggests we are still a good risk. As the deficit shrinks, we’ve also seen a slowing in the supply growth of new bonds at the same time that demand from outside sources, such as Japanese buyers and investors in need of high-quality collateral, increases. After an initial adjustment period, the net change in rates might end up being small for some time.

Even so, the shift from a Fed-determined rate that was relatively stable to a market-determined rate that may not be introduces another layer of volatility into the pricing of all securities.

Think of security pricing—bonds, stocks, and everything else—as a building. The risk-free interest rate, usually represented by the U.S. Treasury bond rate, is the foundation of all of those prices. As assets become riskier, more and more required return is added to reflect the risk. Corporate bonds, for example, have firm and industry risk, and therefore yield more than Treasuries. Mortgage bonds have prepayment and collateral risk, and therefore yield more than Treasuries. Moving to the top of the building, stocks have market risk, firm risk, economic risk, operational risk—the list goes on and on—and therefore have to return a lot more than Treasuries. The point is that this isn’t additive but multiplicative. The additional required return change is higher for riskier assets than the change in the base interest rates.

Over the past couple of years, the foundation of this risk structure has been reinforced by the Fed. With a solid foundation, the prices of other assets were certainly volatile, but only for their own reasons—not because the foundation was shifting underneath them. With the Fed starting to remove that reinforcement, the building is now moving in the wind, as it did before, but it’s also more vulnerable to shifts in the ground beneath.

What this means is that, as the shifts in the foundation move up the risk levels, they become more pronounced. Relatively small shifts in base interest rates can have large results at the upper levels of the building. We’ve seen this in the past, and we may be starting to see it in the stock market results.

This is still early days in the Fed exit process, which actually hasn’t even started yet. Again, even if the outcome for interest rates is modest, the effects on riskier assets should be more pronounced. Because of this, current market volatility is probably a precursor of more to come.

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