Fitch Ratings downgraded its US debt rating on Tuesday from the highest AAA rating to AA+, citing "a steady deterioration in standards of governance," and it expects the US fiscal situation to continue deteriorating over the next three years.
On Wednesday, US stocks closed lower, with the Nasdaq experiencing its largest single-day decline since February, led by a downturn in technology stocks.
Why would downgrade affect stocks and Treasuries? What about US dollar? How do they affect each other? How will market move when one of them changes?
Let’s learn about the major assets and their relationship!
1. Three major factors affect US stocks: earnings, risk-free interest rate, and risk appetite
These three factors are also referred to as the numerator (earnings) and the denominator (interest rates, risk appetite).
When earnings improve, the numerator rises, providing upward momentum to the stock market.
When monetary policy is accommodative, interest rates decline, reducing the denominator and pushing the stock market higher.
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It is necessary to differentiate between value stocks and tech stocks.
Value stocks are, primarily driven by earnings changes.
Tech stocks, on the other hand, usually have high valuations and fast growth, mainly influenced by changes in the denominator (interest rates).
Therefore, when interest rates rise, value stocks benefit, and $DJIA(.DJI)$ outperforms the $S&P 500(.SPX)$ and the $NASDAQ(.IXIC)$ ; when interest rates decline, the opposite is true.
2. Factors influence US Treasury yield: interest rate and market behaviors
When institutional investors allocate assets, an important consideration is matching asset returns with liabilities. US Treasury yield serves as an anchor for global liabilities, and an increase in US Treasury yields can raise the cost of liabilities, leading to adjustments in the asset side.
US Treasury yields are positively correlated with benchmark interest rates, which also determine rates for ordinary savings and mortgages. When foreign investors buy US assets, they do so through purchasing US Treasuries, and higher benchmark interest rates result in higher US Treasury yields.
Treasury yields are classified into short-term, intermediate-term, and long-term, corresponding to 1-2 years, 5-10 years, and 30 years, respectively. Short-term yields reflect monetary policy direction and liquidity conditions, while long-term yields reflect economic growth.
3. Determinants of the US Dollar: domestic economy and comparisons with other economies
When discussing the US dollar's trend in the market, it usually refers to the US dollar index, which reflects the economic and financial conditions of the US compared to other non-US economies such as Europe and Japan.
In simple terms, if the US economy is better than Europe or if the US monetary policy is tighter than Europe, it implies that US Treasury yields are higher than in Europe.
According to the interest rate parity theory, capital flows out of low-interest-rate countries and flows into high-interest-rate countries, leading to a stronger US dollar.
When the US economy is strong, other economies like Europe and Japan are weaker, the US dollar appreciates. However, if other economies are stronger than the US, the US dollar depreciates.
When the US economy is weak, US Treasuries fall. If Europe's economy is weaker, the US dollar appreciates, but if Europe's economy is not that weak, the US dollar depreciates.
Conclusion
Each category of determinants is related to interest rates, but not entirely consistent. This is why considering only the binary relationship between interest rates and assets may seem to lack regularity.
In fact, clarifying the relationship between asset price determinants and interest rates is essential to better understand the link between interest rates and the US dollar and stocks.
We can draw conclusions as follows:
Generally speaking, US Treasury yield is positively correlated with benchmark interest rates. When foreign investors buy US assets, they do so through purchasing US Treasuries, and higher benchmark interest rates result in higher US Treasury yields.
Generally speaking, US stock market is negatively correlated with US Treasury yield and interest rate.
In May 2013, when Fed Chairman communicated about "tapering" (tightening liquidity, leading to an increase in US Treasury yields), global stock, bond, and currency markets were greatly impacted, known as the "Taper Tantrum." In February 2021, the rapid rise in US Treasury yields also triggered a significant stock market pullback.
How do you understand the relationship between the four factors?
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