Why stocks prefer stable, modest 'Goldilocks' interest rates

Yahoo Finance Markets and Data Editor Jared Blikre, who also hosts Yahoo Finance's Stocks in Translation podcast, explains why stocks (^DJI, ^GSPC, ^IXIC) favor "Goldilocks" interest rates — that is, stable rates that aren't too high nor too low.

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Video Transcript

00:05 Speaker A

Alright, thank you. Take care.

00:07 Speaker A

On Thursday, a pair of fraud headlines from regional banks spooked the markets. Long-term US interest rates fell below 4% for the first time since April.

00:15 Speaker A

Lower rates are good for borrowers, but then why does that sometimes give stocks a headache? And for that matter, why do rates surging higher also give stocks a problem at times?

00:26 Speaker A

At on today's stocks and translation, we are going to decode the signals from the fickle bond market to tell you why stocks seem to like Goldilock interest rates, not too hot, not too cold and not too volatile.

00:43 Speaker A

Let's start out with the 10-year US Treasury yield. It's Uncle Sam's interest rate for borrowing 10 years out and it's the benchmark that guides longer-term US consumer rates, like for mortgages.

00:58 Speaker A

And it's important to remember that bond prices move opposite their yield or rate. So when investors scramble for bonds in a panic, bidding them up, that's actually moving their yields down.

01:11 Speaker A

Here is your cheat sheet on how the bond market wags the stock market. When rates climb too high, that raises borrowing costs, which can cause consumer buying on credit to slow down. It also makes some of the companies unprofitable.

01:25 Speaker A

But if rates drop too low, that can be a signal that investors are rushing into the safety of bonds, thinking that the economy is slowing down, a classic growth scare signal.

01:37 Speaker A

Most importantly, it's usually not the level of interest rates that matters. It's how fast they are getting there. A quick move to the upside or the downside triggers big institutions to cut down their risk and stocks automatically get sold.

01:49 Speaker A

That's the feedback loop.

01:50 Speaker A

Now, let's review events in the recent past from a volatility perspective. Here we're showing a one-month history of the VIX volatility index, carrot VIX, which is calculated from stock options going out 30 days into the future on the S&P 500.

02:08 Speaker A

This is where you see footprints of big institutions, and when it surges higher, stocks tend to sell off.

02:14 Speaker A

Now, towards the right, you're going to see two spikes higher. The first was on October 10th, when President Trump threatened new tariffs on China.

02:22 Speaker A

While stocks shot higher on Monday, the Vix didn't pull back that much and it stayed elevated. So the market was primed for another shock, which we got on Thursday, October 16th.

02:34 Speaker A

That was when two smallish regional Fed banks or regional banks disclosed an ongoing fraud investigation. Not cataclysmic, but with big investors already on alert, the Vix spiked a bit higher into the mid 20s.

02:48 Speaker A

Now let's check out the same time frame with the bond market's volatility index, which is called the Ice B of A move index. Its ticker on the Yahoo Finance site is Carrot MOVE.

02:59 Speaker A

You're going to notice similar movements in reaction to the two scares, but not as extreme as the VIX.

03:06 Speaker A

In fact, Thursday's spike up took it to the same level as a prior Friday's. This happened as a 10-year yield dropped under 4% for the first time since April.

03:16 Speaker A

And putting it all together, this suggests that the bond market wasn't quite as reactive as the stock market. So big institutions were not forced to mechanically dump stocks, at least in panic mode.

03:29 Speaker A

Translation, this last week is not yet signaling any big change in economic conditions, but markets are more primed for future scares. Think of it as a ratcheting effect.

03:41 Speaker A

So bringing it home, here's what to watch next in this saga.

03:47 Speaker A

First, we want to watch the market's volatility gauges, the Vix for stocks and the move index for bonds. Are they cooling off or are they staying elevated? Are they ratcheting up or are they ratcheting down?

03:57 Speaker A

Then you want to watch the US 10-year yield. We already climbed back over 4%, which suggests that the scare over bank fraud was a little bit overdone. But remember that volatility is more important than the actual levels.

04:09 Speaker A

Then, be on alert for any more negative credit headlines, whether bank fraud or simply consumers defaulting more on auto loans or mortgages, surprises ratchet up tensions, which weigh on stocks.

04:22 Speaker A

And finally, listen to what Fed officials say. They tend to be very careful and measure their words. But if the read through is growth scare as opposed to soft landing, markets are going to get jittery.

04:35 Speaker A

Bottom line, as long as things don't move too quickly, the risk rally with stocks pushing up against all-time highs should continue, but there is a breaking point and that's what we're trying to gauge.

04:49 Speaker A

And tune in the stocks and translation podcast for more jargon busting deep dives. New episodes can be found Tuesdays and Thursdays on Yahoo Finance's website or wherever you find your podcast.

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