Sudden and substantial rise in real interest rates could cause significant drop in US stocks

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New Delhi, Jan 28

 A large and sudden jump in real interest rates could lead to a further selloff in US stocks, according to an International Monetary Fund (IMF) blog.

Despite somewhat tighter monetary conditions and the recent upward move, longer-term real rates remain deeply negative in many regions, supporting elevated prices for riskier assets. Further tightening may still be required to tame inflation, but this puts asset prices at risk. More and more investors could decide to sell risky assets as those would become less attractive, the blog said.

The unprecedented low real interest rates continue to boost riskier assets, notwithstanding the recent upward move. Low long-term real rates are associated with historically elevated price-to-earnings ratios in equity markets, as they are used to discount expected future earnings growth and cash flows. All things being equal, monetary policy tightening should trigger a real interest rate adjustment and lead to higher discount rate, resulting in lower stock prices.

Despite the recent tightening in financial conditions and concerns about the virus and inflation, global asset valuations remain stretched. In credit markets, spreads are also still below pre-pandemic levels despite some modest widening recently.

After an exceptional year supported by solid earnings, the US equity market started 2022 with a steep retreat amid high inflation, uncertainty about growth and weaker earnings prospects. As a result, we expect that a sudden and substantial rise in real rates could cause a significant drop for US stocks, particularly in highly valued sectors such as technology, the IMF blog said.

Already this year, the 10-year real yield has increased by nearly half a percentage point. Stock volatility soared on greater investor nervousness, with the S&P 500 down more than 9 per cent for the year and the Nasdaq Composite measure tumbling 14 per cent.

Our growth-at-risk estimates, which link future economic growth downside risks to macro-financial conditions, could increase substantially if real rates rise suddenly and broader financial conditions tighten. Easy conditions helped global governments, consumers, and businesses withstand the pandemic, but this could reverse as monetary policy tightens to curb inflation, moderating economic expansions.

In addition, capital flows to emerging markets could also be at risk. Stock and bond investments in those economies are generally seen as being less safe, and tightening global financial conditions may cause capital outflows, especially for countries with weaker fundamentals, it added.


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