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Get ready for lower stock prices

By Sheyna Steiner ·
Friday, September 27, 2013
Posted: 3 pm ET

The impact of tapering on bonds is well-known. Just the idea that the Federal Reserve would reduce asset purchases sent Treasury yields up and prices down over the last few months.

But what about stocks? A paper out this week from Research Affiliates looked at the impact on equities and other risky assets. Rising interest rates typically mean good things for most stocks, but not necessarily because of interest rates themselves. Rather, when interest rates go up the economy is moving faster, inflation is heating up and the Federal Reserve is trying to slow growth down.

"Rising rates suggest faster GDP growth, better ROIs and a greater demand for investment capital," according to the report "The impact of tapering on risky assets."

But the prevailing dynamic in recent years has been one of across-the-board correlation among asset classes. That means that all sorts of investments experience volatility at the same time -- for instance, Treasury bonds and stocks in general.

Underpinning that dynamic are very low interest rates. With the cost of borrowing very low, some enterprising traders and institutions have been able to borrow money at very low costs and invest the funds in high-yielding assets in other currencies -- specifically emerging markets. Borrowing money in one currency at a very low interest rate to invest in another currency for higher yields is called a carry trade.

"The carry trade could be people borrowing at low U.S. rates to invest in high yielding (emerging markets) local currency debt, or people taking money out of their U.S. fixed income investment to invest in high yielding (emerging market) local currency debt," says Jason Hsu, chief investment officer at Research Affiliates.

As the economy moves toward a more normal interest rate environment, the benefits of borrowing to invest will evaporate. According to Hsu's paper, stock prices will fall as investors move back to less risky assets. That may be a good thing: In addition to creating a buying opportunity, correlations among asset classes will likely go down.

What impact do you anticipate from tapering?

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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.

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