Bond yields rise, investors sweat: Why interest rates matter

The yield on 10-year U.S. Treasury bonds touched 3 percent last week for the first time since 2014, after flirting with that level for a few months. As the benchmark neared, many investors worried increasingly whether stocks would drop. They did.

But the true effect of hitting 3 percent is more psychological than scientific. Rather than letting the headlines make you fearful, this milestone is a great chance to refresh your grasp of how the bond market affects the stock market and what you can learn from rising interest rates.

Here's why you should watch interest rates — but also not get swept up and scared that rising rates will destroy your portfolio.

Though it may seem counterintuitive, investors worried about a stock market crash should be watching the market for U.S. Treasury bonds. How bonds move — that is, investors' expectations for the future trajectory of interest rates — is perhaps the best indicator of how the stock market as a whole will move.

While the stock market gets all the headlines, the bond market is much larger and arguably more important to the economy.

As of January 2018, the size of the U.S. bond market (as measured by debt outstanding) was nearly $41 trillion, compared with about a $30 trillion value for the U.S. stock market.

As for importance, while the stock market measures the value of America's publicly traded companies, the bond market shows how much interest investors are willing to accept for tying up their capital for a period of time. In other words, the bond market measures the cost of money.

Interest rates determine to a large extent how investors will price stocks, so over time the stock market pivots on moves in the bond market. Although the two markets are separate, they often react off one another.

Here's how: Where interest rates are and where they are going help you figure out if the economy is growing and whether stocks are likely to move higher.

The Federal Reserve tends to raise interest rates when economic growth is robust and inflation is rising. People are out spending money, and the demand pushes up the price of goods and services, what's known as inflation. Rising consumer and business spending is usually good for corporate profits — and when investors expect rising profits, they drive stock prices up. Interest rates peak near the end of an economic boom.

When the economy is no longer able to grow, the Fed lowers rates to encourage consumer and business spending to reignite the economy. When rates are going down, corporate profits languish and investors bid down stocks.

So interest rates help to tell you where stocks as a whole are going — maybe not next week or next month, but over a longer time frame.

Higher interest rates mean investors take a dimmer view of a company's future profits.

There's another reason stocks react to the bond market. It's more technical, but it explains some of those swift "corrections" that arise amid a strong bull market.

It's based on the principle of the time value of money — that one dollar today is worth much more than one dollar in 10 years. How people value that future dollar depends on interest rates. When rates go up, a future dollar is worth less. The further into the future, the more that dollar is discounted. So to offset a current rise in interest rates, investors demand more future money.

For example, with interest rates at 5 percent an investor would accept equally $1 today or $1.05 next year. If rates rose to 6 percent, an investor would accept $1 today but would demand $1.06 next year.

The same thing happens with stocks. Investors price a company's stock as the value of all its future cash flows discounted back to the present. If interest rates go up, those future cash flows are worth much less today.

So if investors anticipate rapidly rising rates, they will push down stock prices — sometimes drastically — because the models say the value of a company's future cash flows has declined. And if investors' expectations change, resulting in spiking interest rates, stocks can plunge, even in the midst of a longer-term bull market.

The interplay between interest rates and stock prices was evidenced in February, when the market took a swift dive as investors feared the Fed might raise rates more times this year than expected. The pros were out making short-term trades, as they hung on every change in the Fed's public pronouncements. But this is not a great investing strategy for individuals.

Yes, interest rates are a reasonable gauge of how stocks might perform over time. But an even bigger factor is the quality of the company behind the stock. Some of the best long-term investors don't worry much about rising rates and instead focus on owning well-managed companies that are growing their profits.

So when the market dips, good investors are buying more of their best stocks while they are on sale — setting themselves up for huge gains for years to come.

James Royal is a writer at NerdWallet. E-mail: jroyal@nerdwallet.com.