voilà! interest rates

One of the main factors that affect prices of any asset held for investment is the interest rate. The more it changes, the more it affects the prices and thus, the investment performance.

So, we have the scapegoat, blame it on the rates.

For bonds it is quicker: It is quite clear that when interest rates go up, bond values fall and vice versa.

For equities it is gradual but sure: For equities, it is the same since the current alternative options (bonds) appear to be more attractive. The opportunity cost of investing in equities goes up, and consequently, their intrinsic value goes down. Cost of borrowing goes up when interest rate goes up. Equities will appear to be overvalued if their prices don't fall to a level that is reasonable. To adjust to a more rational market values, it will take more time for equities than for bonds.

Inflation also is affected by the level of interest rates. So, watch out for that long-term, risk-free government bond rate.

Here's the historical information of the long-term rates in India and US.

Low interest rates during the period 2002-2005 made immense sense to invest in equities rather than bonds. For the last 2 years we have been in the 8%-regime, which is also the mean rate over the long period. One reason it has been holding on to that level is the level of inflation. It hardly makes sense to invest in a risk-free rate lower than inflation. We can argue that when inflation is tamed down, interest rates are more likely to go down. I cannot make a prediction on that.

US is experiencing one of the lowest interest rate periods in its 100-year history. While the economy did extremely well since low rates of 1940s, it is a challenge for it now to replicate its past performance simply because of its sheer size. Now if it can clock a growth rate that is 1.5-2 times its long-term rate it will be a stupendous performance. If you believe in corporate America to increase its profits and cash flows in the next decade and more, this is the best time to invest there. I cannot predict the future rates here as well.

So much for the interest rates and their magical powers.