Why do stocks and crypto assets suffer from interest rate hikes?

Most people associate interest rates with deposits, bonds, loans and mortgages, often forgetting the connection with every other asset. However, interest rates are connected across their full maturity spectrum and with all other asset returns.

Why do stocks and crypto assets suffer from interest rate hikes?
Photo by Andrey Metelev / Unsplash

I have been asked this question several times: Why do crypto assets suffer from interest rate hikes? And from this question, often comes another: Why do growth stocks suffer more than value stocks from such rate hikes? Most people associate interest rates with deposits, bonds, loans and mortgages, often forgetting the connection with every other asset. However, interest rates are connected across their full maturity spectrum and with all other asset returns. As a rule of thumb, interest rates and asset prices are inversely connected.

A financial asset requires you to disburse money today to purchase it on the promise (or expectation) of reaping future inflows. These inflows may come in the form of periodic income payments and/or capital gains. If you buy a 10-year bond from the US government, you're expected to receive periodic coupons (eventually twice a year) and a final payment for the face value of the bond. In order to know how much these payment are worth, you must discount them to the present. However, \$1 today isn't the same as \$1 tomorrow or in ten year's time. To take the time value of money into account we should use a rate of discount, which in the case of bonds is many times referred to as yield. This yield represents an opportunity cost or the return required by investors to place their money on that particular bond issue. The higher the risk, the higher the yield, as investors must be compensated for more uncertain cash flows.

Riskfree rates, discount rates and duration

The lowest possible yield should be equal to the rate of return required by investors to place their money on an investment without risk (if that really exists!!!). That's what we often call a riskfree interest rate. A US government bond is (theoretically) riskfree and then its implicit yield can be thought of as a riskfree interest rate for the specific maturity of the bond. Other bonds should trade at higher yields because they carry risk. Following this reasoning, we can say that the discount rate is at least equal to the riskfree rate. The higher the risk, the higher the compensation investors require, the greater the premium added to the riskfree rate. This explains why the required return on a stock must be higher than the same for a bond. At the premium over the riskfree rate, investors often call the equity risk premium.

When the central bank hikes its key interest rate, the riskfree component of the discount rate increases and so thus the burden on future cash flows. These cash flows are then worth less than before and the current price of assets declines.

As long as the price of any financial asset reflects its future cash flows, it will go down when interest rates increase. However not all assets are impacted in the same way. The more distant the cash flows are from today, the greater the impact of interest rate changes. In the bond market, we use the concept of duration, which is roughly a weighted average maturity for the expected cash flows. For example, a 10-year zero-coupon bond has a duration of 10 years because there's just one cash flow, which will occur in ten year's time. But a 10-year coupon bond will have a lower duration, of for example, 8.2 years, or 6.7 years. The terminal cash flow received at the maturity date is always big in comparison with coupon payments so it skews duration towards the maturity of the bond. However the final number will depend on the number of coupon payments and the specific amount paid each time. All else equal, the higher the coupon payments, the lower the duration. Thus, if interest rates were to rise, you would benefit from assets paying higher interim cash flows.

The concept of duration is important because it tells a lot about the impact interest rates will have on the price of an asset. The lower the duration, the lower the impact of interest rates. Therefore, under the current scenario of low interest rates, I would prefer investing in money market funds or Treasury notes instead of Treasury bonds because there's a higher likelihood of rates going higher and then I would be better with instruments with the lowest duration.

Impact of interest rates on stocks

Let's now turn into the stock market. The stocks quoted in the NYSE, in particular the behemoth companies that make the Dow Jones, usually pay regular dividends at stable growth rates. These companies don't live from the promise of skyrocketing future profits. They're already disbursing a lot to investors in the form of regular dividend payments. These are called value stocks. In contrast with this segment of the market, we have tech stocks, mainly from the Nasdaq market. Many of them live from high promises of future profits but are not currently delivering a cent to investors. Their profits, or cash flows to investors, are expected way into the distant future. These are often called growth stocks. A good example is Tesla and Moderna, which until recently weren't able to post a profit, let alone paying dividends.

While duration applies to bonds, we can still use the concept to understand the differences between value and growth stocks. We can easily argue that value stocks have a lower duration than growth stocks. After all, value stocks are delivering money to investors while those cash flows are just a mirage for growth stocks. Thus, when interest rates rise, growth stocks are expected to suffer way more than value stocks. This is exactly what's happening in the market so far in 2022. While the Russell 1000 Value Index is down 5%, the Russell 1000 Growth Index is down 14% YTD.

Russell 100 Value & Russell 100 Growth vs. S&P 500

Crypto assets

Let's proceed towards crypto assets. These assets don't pay dividends. Most of their current value comes from an expectation about their future use cases. Crypto often trades on very high promises that extend way into the future. As you already guessed, crypto assets are like growth stocks, but with an even longer duration. Higher interest rates are a heavy burden on their distant expected gains.

Crypto vs. S&P 500
Bitcoin and Ethereum vs. S&P 500

As you can see in the chart above, while the S&P 500 is down 8% YTD, bitcoin and ethereum are down 21% and 35%, respectively. These losses are way higher than those for growth stocks.

I'm not saying that under rising interest rates, growth stocks and crypto will underperform the rest of the market. There's more than interest rates to account for. If inflation is rising faster than interest rates, the real interest rate is declining and the dollar may suffer accordingly. When that happens, crypto assets, in particular cryptocurrencies may get an edge if they live to the promises of replacing fiat money. But, whenever the Fed gets the edge over inflation by tightening its policy faster than expected, the US dollar rises and whatever currency is at the other side, suffers. That's particularly the case with crypto currencies like bitcoin and ethereum.

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