Stocks and Bonds Both Elevated By Low Rates

Assume you worked hard your entire life and amassed a nice nest egg, allowing you to retire if you could earn an average of 5.00% annually. That plan would not have required you to take a lot of risk when CD rates were above 5.00% in the 1980s and 1990s (see below).

Search For Higher Returns

However, when CD rates started to fall well below 5.00%, you would have been forced to either lower your income expectations or add higher-yielding investments to your retirement portfolio. The search for yield has created additional demand for riskier assets, including stocks.

Higher Rates Reduce Demand For Stocks

For illustrative purposes, if we assume the Fed raised rates back to 5.00% this month, it is easy to understand how many investors would no longer feel the need to invest a portion of their portfolios in higher-volatility assets, such as stocks. Higher rates reduce demand for riskier assets, which in turn can lead to a decline in stock prices. If we knew stocks and CDs would both produce an annual return of 5.00% over the next decade, most would prefer to own the lower volatility asset (CDs).

Bonds Have Benefited As Well

If you invested in a 30-year bond paying over 6.00% in 1999, you would be quite happy with that portion of your portfolio. Fast forward to 2016 when long-term bonds are paying closer to 2.00%. Basic supply and demand tells us most people would rather have a bond paying 6.00% per year than one paying 2.00% per year, which is why bond prices tend to benefit from lower rates. When rates begin to rise, the relative attractiveness of higher paying bonds begins to drop, which is why bond prices tend to fall when the Fed starts to raise rates. The relationship between interest rates and bond prices is based on supply and demand.

Lowering Rates And The Wealth Effect

The wealth effect refers to potential economic benefits created by rising asset prices. When your 401(k) is rising, you feel better about your financial standing. Consumers who feel good about the future tend to spend more, which can be beneficial to the economy. The Fed hopes to stimulate the economy via the wealth effect when they lower interest rates.