Do Rising Rates Mean Falling Stocks?

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Jun 11, 2015 12:54:08 PM

and tagged In the News

Leave a comment

rising ratesYesterday, I saw an interesting doom-and-gloom piece on rising rates, which claimed that rate increases typically sink the stock market and that we could potentially expect a crash in the near future.

Theoretically, this isn’t crazy; higher rates should lead to lower stock prices. In practice, though, higher rates typically reflect a strengthening economy. The effect on stock prices is a battle between the tailwind of faster earnings growth from an improving economy and the headwind of higher rates. Only in the absence of the tailwind does the headwind become significant.

There are real problems with rising rates, principally in emerging markets that have borrowed extensively in dollars, but here in the U.S., higher rates are increasingly a consequence of an improving economy. Rather than a promise of impending trouble, they’re a sign of ongoing success.

What does history tell us?

Let’s take a peek into the past to see how rising rates have actually played out in relation to stock market performance.

Looking at the period from 2006 through 2010, we see that rates and stocks moved more or less in tandem, the opposite of what theory would suggest, at least until the end of 2010. Especially in 2009, rising rates did not preclude rising stocks, showing that a short-term relationship can be positive rather than negative.

rising_rates_1

Over a longer and more typical period, the last 10 years, we do see a negative relationship, as we would expect, but it is not very strong. The correlation of −0.27 says that rising rates may drive stocks down, but not very much at all, at least at the moment they change.

rising_rates_2

This is where things get interesting. Interest rates do affect stocks, but not very much at the moment rates change. If you think about it, though, it takes time for changes in rates to move through the economy, so we should expect a lag.

What does the relationship look like if we compare changes in rates with changes in stock prices at a later period? This chart shows the past 10 years with a 30-month lag, the point at which the relationship is at its strongest. Here, there is almost a 90-percent negative correlation between interest rates and stock prices.

rising_rates_3

This really does show that when rates rise, stocks eventually go down, consistent with economic theory. Not only that, the relationship persists beyond the past 10 years. Looking at the past 30 years with a 30-month lag, we see essentially the same relationship and the same correlation.

rising_rates_4

From a fundamental standpoint, this makes a lot of sense. The initial rise in rates is typically a response to an improving economy, which drives stocks higher. On average, it takes two to three years for the economy to start to overheat and for rates to get high enough to start to choke off growth—which is when stocks decline. This is exactly the pattern we see here.

Bottom line: rising rates not an immediate threat

Although higher rates will probably hurt the market eventually, that point is likely a couple of years away. In fact, rate increases early in the cycle are typically associated with continued market rises rather than declines. Plus, although rates have increased, they haven’t really moved above levels typical of the past several years.

Overall, rising rates will no doubt create problems, especially in foreign markets. Here in the U.S., though, there should be no direct concerns for a while.

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®