I posted this video this morning. In it, I argue that economics says that high interest rates should drive down stock prices. But that’s no longer true in 2021, because the real world doesn’t work the way economics says. Instead, high interest rates have led to high stock valuations. And now everything could change.
The audio version of this video can be found here:
The transcript reads:
High interest rates have led to high share prices in the UK.
Now I know I upset a lot of people by saying that, but I’ll say it again.
High interest rates have led to inflated share prices in the UK and, I suspect, globally. And that is one of the reasons why we are now faced with market volatility in the world’s financial markets and the risk of recession, as inflated stock prices threaten to fall.
What I am saying is the opposite of what I am supposed to represent as an economic idea. According to conventional economics, stock prices should fall when interest rates are high. But they didn’t. Since 2021, and I’ll take the UK as an example, the interest rate has risen from 0.25 percent — which is the Bank of England’s base rate — to 5.25 percent and has just fallen for the first time — is currently at 5%.
Over the same period, the FTSE share price index rose from just over 5,000 to almost 8,400. And if we go from mid-2021 to the events of July 2024, the increase was from around 7,000 for the FTSE 100 to 8,400 — a 20% increase in the index, which of course does not mean that all the share prices rose by that amount.
What is clear, however, is that the claim that high interest rates would lower stock prices was not true during this period. Anyone who wants to tell me that I am completely wrong when I say that high interest rates have led to high stock prices is, in my opinion, claiming a falsehood, because I see evidence of the opposite in the real world around me, not just in the UK, where I just noted the figures, but also in the US and elsewhere.
So what really happened? Well, let’s explain it as simply as possible.
Those who claim that high interest rates will lower stock prices are following what is known as economic theory. And economic theory makes some pretty strange assumptions. One is that there are fair markets, and another is that there is perfect information and everyone behaves rationally. And to be clear, none of these things are true.
For example, let’s talk about interest rates.
Interest rates are not subject to a fair market. Interest rates are essentially set by central banks, which have the power to force the markets they regulate to raise interest rates if they say they expect the market to do so.
And to use the UK example, because the Bank of England raised interest rates, which it did, it pushed down the price of government bonds. Most people don’t understand this connection, so I would like to explain it very briefly using a very simple and somewhat exaggerated example.
Suppose we have a government bond issued at £1,000 for a very long period of time, say thirty years.
And let’s assume that it has been an issue for five years now and that it pays an interest rate of five percent. In other words, for every £1,000 worth of bonds you own, you will earn £50 in interest each year.
Now the interest on £50 never changes over the life of the bond, but the bond can be bought and sold. So if the Bank of England decides to raise interest rates after five years, it will actually have to lower the price of the bond.
For example, if she wanted to increase interest rates from the 5% at which the bond was issued to 10%, she could push the price of the bond down until it was at £500 and then £500 would be £50 interest still paid of course a 10 percent return on the new price at which the bond was sold on the used market, and I emphasize very heavily “on the used bond market”, so you can see that bond prices will definitely have to fall if interest rates go down climb.
Now, those who follow conventional economics assume that if the interest rate rises, the stock price must fall because there is a more attractive alternative for funds, namely buying these bonds.
But these bonds are not readily available because when the bond price falls, we don’t have a free market for investment. We have a very heavily regulated investment market where mutual funds are typically required to report on their performance every three months and are always keen to demonstrate an underlying increase in their returns.
So if it appears that the price of the bonds will fall and the fund needs to report a change in its market valuation, meaning that holding those bonds means the value of the fund will fall, then they will sell those bonds. Then they will sell these bonds as quickly as possible because this avoids the risk of loss.
Now, of course, they deliver exactly what the Bank of England wants. The price of bonds falls. But all the money that was in these bonds doesn’t just disappear, it has to go somewhere. And what we know is that most institutional funds are very reluctant to hold cash for the very good reason that holding cash is high risk for them because there is no guarantee on their bank deposits.
So you have to hold assets. And the only other obvious asset they could buy if the price of bonds has fallen is stocks. They will not go into land, buildings and things like that because even for most of these funds they are very long-term structural investments. Instead, they will buy some stocks on the stock market.
The price of these shares on the stock market will then increase due to increasing demand. This is how markets work. Well, that’s irrational, you might say, because certainly they can get a better return on bonds than on stocks, because if the dividend doesn’t go up because you buy more stocks, there’s no reason why it should be, because their return has surely fallen then?
But and here’s the catch. Suppose the person buying the stocks can convince himself that it actually makes sense to buy those stocks, even if there is no evidence to really support that fact. We have observed this phenomenon over the last three years.
What we have seen is the phenomenon of AI developing and coming to market. And anyone who has tried to justify why they are buying stocks instead of bonds whose prices are falling could say, “That’s fine.” We can pay more for the price of stocks because AI will deliver extraordinary profits in the future that will give us justify buying now before the price rises even further as these gains are realized.”
This is all a myth, of course. Nobody knows that AI will achieve extraordinary profits in the future. AI could be an absolute disaster. It may not work. It may not deliver the results people expect because let’s face it: as good as the internet was, it didn’t deliver all the hype that was talked about around the year 2000 and just before.
And therefore there is a possibility that this AI boom is just a myth. The reality now is that we may be facing a real recession because of this. But by the time they realized that AI might just be an old myth, markets could convince themselves that it was entirely rational to use the money they had made by selling bonds whose prices had fallen were to continue issuing shares, the price of which rose as a result.
Even though economic theory supposedly says otherwise, they were able to convince themselves that buying stocks and raising their prices was rational because of the institutional structure of investing, which requires them to put their money somewhere. And we have seen these prices rise until recently when they began to fall.
Contrary to all economic theory that says high interest rates should lead to low stock prices, our central banks set high, even aggressively high interest rates, and at the same time we had high stock prices.
Those who tell me that I don’t follow the theory and that I’m wrong should really open their eyes and look out the window, read their newspapers, look at the charts published on the Internet or whatever else they like.
Because the real world data shows me that high interest rates have driven up the stock price. I see no other explanation. Of course, a myth was used to justify this price inflation, but without the money that came from selling bonds to purchase these stocks, this would not have happened.
And that cash has moved from bonds into stocks. And that’s why the stock price was increased. And that’s because of the change in interest rates. And I believe that is a fact. At least that is my explanation for this situation. And I stick with it because, in my opinion, it is the most accurate explanation of why we are now in such a vulnerable position.
Interest rates must fall because they are too high to sustain the economy, and the myth that has supported high stock prices may also burst. When both happen at the same time, we face a potential problem.
The lower interest rates could stimulate the economy somewhat in the long term.
The decline in the value of stocks and the destruction of the myth of AI, which may well occur, will result in an immediate loss of business confidence that could result in a recession.
We are in a very dangerous place. And excessive interest rates, in my opinion, explain why this is the case.
