Could Rising Interest Rates Hurt Stocks?
During the last week of May, the rate on the 10-year Treasury bond rose to 2.15 percent, the highest since April 2012.[i] Since bonds are priced off of the Treasury spot rate curve (both in discounting the present value of the bonds’ future cash flows and in the spread relative to the spot rate curve), it was not surprising that the value of the majority of bonds dropped at the same time. However, the stock market also gave back some of its double-digit gains for the year. Although the historical correlation between long-term Treasury bonds and stocks is close to 0 (i.e. there is no linear relationship between the two), the correlation between the two has fluctuated significantly in the past. For example, as interest rates steadily declined over the past three decades (since interest rates and bond prices move inversely to each other, bond prices rose), both bonds and stocks performed well. As a result, there was a positive correlation between the two during this long time period.
However, during the recent recession, there was a negative correlation between stocks and bonds. This resulted from the risk-on-risk-off trading mentality of investors. If news (economic, monetary, etc.) was considered positive, stocks increased while Treasuries sold off. If news was considered negative, stocks declined while Treasuries were bid up. Furthermore, a Deutsche Bank report found that since 2000 rising bond yields (and thus falling bond prices) have been associated with rising stock markets: U.S. equity returns were positive in 71 percent of months with rising bond yields.
As the above graph indicates, it is not a foregone conclusion that a rise in interest rates will cause stocks to perform poorly. Why do investors think that higher interest rates are bad for stocks? First, similar to bonds investors attempt to identify the true value of a stock by finding the discounted value of future cash flows. If future cash flows are discounted at a higher interest rate, then the present value of those cash flows – and thus the stock’s current intrinsic value – is lower. Second, higher interest rates could hurt the economy over the short term by encouraging less lending and spending and more saving. This is the reason the Fed has continued to purchase Treasuries and mortgage bonds: the Fed doesn’t want rates to rise and risk hurting the economic recovery. By using just these two reasons, higher interest rates should be a net negative for stocks.
Does this negative relationship between stocks and interest rates always hold? As explained previously, the correlation between stocks and bonds (and therefore interest rates) fluctuates significantly. In the report by Deutsche Bank, strategist Francesco Curto examined the relationship between stocks and bonds in 1994. In 1994, the Fed had kept rates at 3 percent for three years in order to help the economy recover from the savings and loan crisis. Then the Fed unexpectedly raised the Fed funds rate by 25 basis points.[iii] Consequently the bond market had its worst year since the late 1920s. How did stocks perform during this time of rising rates?
The S&P 500 lost 9 percent from February-April 1994 and bond yields rose over 3 percent throughout the year. Following this time period, economic growth picked up, and the S&P 500 rose by 40 percent over the next 14 months and bond yields declined by 2 percent. If economic growth increased to a point – say 2.5+ percent annually – that the Fed felt comfortable decreasing their monthly bond purchases, it does not necessary mean that the stock market is going to perform poorly because of the higher rates. A moderate increase in rates could allow for the return to historically more normal rates. This would allow individuals with net savings to receive more interest income from their savings accounts and money market funds. Moreover, banks might become more apt to lend to individuals. Banks receive the spread between what they pay to depositors and what they charge on loans. Since banks typically pay depositors at short-term interest rates and then lend to individuals, businesses, etc. at long term rates, banks tend to be more profitable when the yield curve is steep (long term interest rates are higher than short term interest rates). Since the Fed has been buying more long term bonds in order to flatten the yield curve, higher interest rates could actually cause banks to lend more. While the stock market did decline in the last week of May, the Dow gained over 400 points during the month even though the 10-year Treasury yield increased from 1.63 percent to 2.16 percent.[v]
Similar to 1994, recent large interest rate increases have been a negative to stocks in the short term. Investors tend to focus exclusively on the interest rate change rather than the positives that might have helped push rates higher: economic growth, improving employment situation, etc. The 10-year Treasury rate increased by 32 percent in May, but the stock market ended the month in positive territory. Since 2000 there have been two other times when long-term interest rates increased by more than 25 percent in a year, and in both cases stocks fell by at least 5 percent.
A different way to look at interest rates is to look at the absolute, rather than the relative, level of rates. According to the historical relationship between stocks and bonds, stock markets tend to decline when the 10-year Treasury yields more than 6 percent. This relationship could be because the economy’s nominal (~real + inflation) long-term growth rate is approximately 6 percent. If it costs more to borrow at the risk-free rate than one would receive in return for investing in the economy, then it would make sense for investors to allocate more capital to purchasing safer investments (Treasuries and CDs) than stocks.[vii] Another suggestion involves asset allocation. Investors can choose to put their money in stocks or bonds. The amount of money that is allocated to each depends on investor’s expectations regarding the future risk and return characteristics of each. At that level of interest rates, investors might perceive bonds to be a reasonable substitute for stocks. With investors deciding to allocate a larger portion of their portfolios to bonds, money is removed from the stock market and stocks decline.
As the above graph demonstrates, since 1900 Treasury bond interest rates have been at 6 percent or lower 75 percent of the time. Interestingly, the median rate is 4.0 percent and the average is 4.8 percent. Current rates are 1.9 percent lower than the historical median and 2.7 percent lower than the historical mean. When the level of interest rates is low, the stock market is typically priced higher on a multiples basis. According to Jeremy Siegel, although the current Price-to-Earnings ratio of approximately 17 is close to the S&P 500’s average P/E since 1935, the average P/E of the S&P 500 is 23.6 when the yield on the 10-year Treasury bond is 6.7 or less.[ix]
As noted in our paper regarding rising interest rates and bonds, there are types of bonds that trade similar to equities. One of these types is non-investment grade (high-yield) bonds. Over the past three decades, one fact regarding high yield bonds that has become apparent is their relatively high correlation to equities: U.S. high yield bonds have a correlation of .62 with the S&P 500 Index. Similar to equities, high yield bonds currently trade near record highs. Historically, the success of high-yield bonds has been more of a function of the performance of the overall economy than a function of the level of interest rates. If this relationship were to hold in the future, the performance of high-yield bonds should reflect the global economic outlook. If interest rates were to rise because the economy was continuing to improve, then high yield bonds should do well. However, if a 1970s scenario – high interest rates, but low economic growth – was to occur, high yield bonds would most likely be one of the worst performing asset classes.
While higher interest rates would most likely hurt equities in the short term, a normalization of interest rates to their historical level could most likely signal that the economy is improving. Despite interest rate concerns, the stock market only remains 3.8% from its all-time high set earlier this year. The stock market’s strong year-to-date performance lies on this basic premise: if the economic recovery loses steam, the Fed will continue QE3 – which is positive for stocks – and if economic growth increases, the Fed will start to curtail QE3. Since the historical correlation between stocks and interest rates has been close to 0, we do not believe that a decline in monthly bond purchases by the Fed will automatically push stocks lower over the medium to long term. In contrast, we believe that economic fundamentals will be the main determinant of the stock market’s appreciation in the long term. Although the stock market could remain volatile in the short run, we believe that focusing on low-beta companies with strong free cash flows is still the most prudent move by most individual investors.
*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.
*Indices are unmanaged, statistical composites and their returns do not include payment of any sales charges or fees an investor would pay to purchase the securities they represent. It is not possible to invest directly in any index. Past performance is no guarantee of future results.
[i] Kruger, Daniel. Treasury 10-Year Yield Highest Since April 2012 on Confidence. 28 May 2013. Bloomberg. 3 June 2013. <http://www.bloomberg.com/news/2013-05-28/treasury-10-year-yield-highest-since-april-2012-on-confidence.html.>
[ii] Ro, Sam. No, Surging Interest Rates Are Not a Disaster for Stocks. 2013 June 3. Business Insider. 3 June 2013. <http://www.businessinsider.com/rising-interest-rates-and-stocks-2013-6.>
[iii] The 1994 Effect. 22 Mar 2011. The Economist. 4 June 2013. <http://www.economist.com/blogs/buttonwood/2011/03/interest_rate_risk.>
[iv] Ro, Sam. No, Surging Interest Rates Are Not a Disaster for Stocks. 2013 June 3. Business Insider. 3 June 2013. <http://www.businessinsider.com/rising-interest-rates-and-stocks-2013-6.>
[v] Lim, Paul J. When Interest Rates Rise, Stocks Don’t Have to Fall. 1 June 2013. The NY Times. 4 June 2013. <http://www.nytimes.com/2013/06/02/your-money/when-interest-rates-rise-stocks-neednt-fall.html.>
[vi] Carr, Michael. Rising Interest Rates Point to Possible Stock Market Crash. 31 May 2013. Money News. 5 June 2013. <http://www.moneynews.com/MichaelCarr/interest-rates-stocks-bonds-bear/2013/05/31/id/507287.>
[vii] Lim, Paul J. When Interest Rates Rise, Stocks Don’t Have to Fall. 1 June 2013. New York Times. 5 June 2013. <http://www.nytimes.com/2013/06/02/your-money/when-interest-rates-rise-stocks-neednt-fall.html.>
[viii] Analyzing Treasury Bond Interest Rate History Since 1900. 30 Nov 2010. 5 June 2013. <http://observationsandnotes.blogspot.com/2010/11/treasury-bond-interest-rates-since-1900.html.>
[ix] Siegel, Jeremy J. The Case for Dow 17,000. 19 Nov 2012. Kiplinger. 14 Feb 2013. <http://m.kiplinger.com/article.php?url=%2Farticle%2Finvesting%2FT052-C019-S001-the-case-for-dow-17-000.html.>
[x] Is the Market Overvalued? 19 Mar 2013. Seeking Alpha. 7 June 2013. <http://seekingalpha.com/article/1287521-is-the-market-overvalued.>.