Why falling interest rates and bond yields support stock markets, and when it stops working

In financial markets, it's often said that "bad data is good data." This paradox is especially evident during periods of economic slowdown, when investors rely on central banks to respond. A decline in interest rates and bond yields can act as fuel for stock indices, lowering the cost of capital, increasing valuations and boosting sentiment.

For example in DCF model, used to value companies, a key element is the discount rate, often based on the yield on Treasury bonds. The lower the yield, the lower the discount rate, which translates to a higher present value of future cash flows. For example, if a company generates $100 million in free cash flow annually, at a discount rate of 5 percent, its value is $2 billion. When the rate drops to 3 percent, the valuation increases to over $3,3 billion. This represents an increase of over 65 percent, without changing fundamentals. As a result, even a small decline in interest rates can trigger a significant share price movement.

Therefore, in a high-interest-rate environment, any weakening of macroeconomic data, such as rising unemployment or falling inflation, can be interpreted as a signal to ease monetary policy. As a result, bond yields fall and stock markets rise, pricing in future lower rates and more favorable financial conditions.

However, this mechanism doesn't work forever. There's an inflection point where "bad data" ceases to be "good." This occurs when the data is so weak that it raises concerns about a recession, falling corporate profits, and deteriorating economic fundamentals. At this point, even falling interest rates and yields aren't enough to sustain stock market gains.

This tipping point occurs when investors no longer believe the central bank has effective tools at its disposal, or when monetary easing is perceived as a response to deep structural problems. In such an environment, "bad data" becomes simply bad, and stock market indices begin to decline despite easing policy. One might argue that one can always "turn on the printers" in response to a crisis, but with the current elevated inflation rate, this would only add fuel to the fire.

Therefore, it's crucial not only to understand whether interest rates and bond yields are falling, but also why. If they're falling due to controlled disinflation and a soft landing, that's good news for markets. However, if they're the result of a sharp economic downturn, it could signal the beginning of bigger problems.