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The Interest Rate Myth - A Bullish Argument at Trader’s Narrative

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Rising interest rates are bad for the stock market and since we are now at rock bottom, rates can only go up and take the equity market down with it. This well known shibboleth is put to rest in this short video:

The presentation is persuasive and if you’ve been reading this blog for a while, none of the material should be novel. Based on the fact that the Fed follows, rather than sets the interest rate, I argued for rate cuts back in 2007 and throughout 2008: Why Today’s Cut Isn’t Enough and Fed Will Cut Rates Again Before 2008.

As well, Wayne recently did yoeman’s work by crunching the numbers to establish the relationship between interest rates and stock market performance (covering much more than the time frame in the video above): What Do Rising Rates Mean for Equities?.

I know, I know, it seems bonkers to be bullish right now but that’s what the relationship between the bond market and stocks is implying. That’s how previous market cycles have played out. To inoculate yourself, it helps to remember that the bearish case is always more eloquent and intellectually attractive (Is It All a Ponzi Scheme?).

What do you think? Are you positioned for further gains? or do you think this is a major top? or maybe you’re expecting sideways range bound trading? I’d be interested to hear your opinions as I’m regularly reminded how much smarter my readers are (!).

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3 Responses to “The Interest Rate Myth - A Bullish Argument”  

  1. 1 Wayne

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    Nice timing Babak. Interesting to see that others are on to this misconception.

    I do want to make sure that readers understand that I am not of the opinion that the market has to go up in 2010 just because short term rates are near zero and can’t go lower. I have simply been stating that if short term rates do start back up in 2010, it is not necessarily a bad omen and may actually be conducive to higher equity prices. If you refer back to my original research on this subject, “What Rates Rising from Zero Mean for Equities”, I added an additional comment this morning, where I noted the 4 times since 1970 that the discount rate was below 5% and was raised, reversing a downward trend. In all 4 cases, the market was substantially higher 6 and 12 months later.

    One other current interest rate misconception that I wish to try to clarify, is the perception that rates can’t go lower. Although short rates have found good support at zero (attempt at humor), 30 year bond yields are 4.50% and can drop a great deal from this level. In the fall of 2008, they got as low as 2.8% and the historic average yield spread between Tbills and the 30 year bond is around 1.5%, much less than the current 4% spread. I view a scenario of short rates staying at zero and long rates dropping as the most ominous for equities in 2010, at least from an interest rate perspective. I don’t think this is likely in 2010, but the possible bearish scenario that could develope if the economy double dips in the next 12 months. Rates and the market can go down from here.

    After studying the relationship of interest rates and equities off and on for the last 2 months, I am of the opinion, that there is a very strong correlation (lower rates - higher equities) between the two as long as rates are 5% or higher. The higher rates are, the stronger the correlation. When rates drop below 5%, the relationship breakdowns and seems to even reverse. I believe these statements could be supported by a correlation study, if I could get a moment to do such.

    Old perceptions of monetary policy and stocks need to be rethought in the new low interest rate environment. For example, I was recently reviewing Marty Zweig’s Monetary model introduced in his popular book “Winning on Wall Street” in the mid 80’s. These models were developed based on a study of rates and equity prices using data from 1960-1985, a period when rates were higher than normal. The monetary indicators in that book have failed miserably over the last decade during a period of rate levels not seen during his study. (That is one of the problems with optimization techniques, we have to be careful, that the data in the study is reflective of what we might see in the future as well as what we have observed in the past.)

    I don’t mean to beat up Marty, he is an idol of mine, worth 100’s of millions, and he made the best market call I ever saw on October 16, 1987, at the 6:45 mark of the below youtube video of Wall Street Week, actually calling for a ‘crash’ the day before the 87 crash.

    I would love to get Marty’s take on the current interest rate environment. Do watch the above video, the day a market timing legend was made.

  2. 2 Samuel

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    My main problem with the study is that I believe the 10 year Treasury interest rate to be the most important rate. Not the Fed Funds rate. The 10 year benchmark Treasury is critically important to the debt structure in the Unites States. It is especially important now that the US has a total market debt bubble of over 300% of GDP. As the 10 year treasury benchmark rate rises the higher debt service in the economy grinds the economy to a halt. This has been the main cause of the financial crisis over the past few years.

  3. 3 biscosc

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    I think we could be close to an intermediate top but I also acknowledge that trying to time short-term tops and get back in on pullbacks during a bull market is a fools game. Sit tight and be right! I think people over-analyze because they can’t sit tight and also are over-confident in their abilities. For me, I’ll be sticking with what has worked the last year until something else starts working better. Unfortunately Babak, this advice is only one blog post and you and everyone else needs to generate much more material. I do want to say I appreciate all your work and you have one of the best blogs around! Happy Holidays!

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