The Independent Market Observer

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

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

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

and tagged Market Updates

Leave a comment

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.

Subscribe via E-mail

Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®