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This is another fantastic guest post by Wayne Whaley, CTA. This time we’re treated to an intriguing historical study of the relationship between interest rates and equity prices.
Yesterday I touched on this very tangentially through the SocGen report on the relationship between inflation and P/E ratios but this goes into much more detail on the true inter-play between the two biggest markets, fixed income and equities. If you’re rushed for time, jump towards the end for a summary of conclusions:
The historical correlation between interest rates and future equity prices is well documented with an abundance of existing studies to support the correlation. For a small sampling of trading strategies tied interest rates, simply google “Three Steps and a Stumble”, “Two Stumbles and a Jump”, or “Don’t Fight the Fed”. The trading theory is very straight forward, “A trend of lower rates tends to be conducive to higher equity prices and vice versa”.
This concept is based on the generally accepted principle that interest bearing securities are the primary source of competition for equity investment dollars. Higher expected returns for one investment, reduces the appeal of its primary alternative. Also, the cost of borrowing money has an influence on the expense of doing business for many companies, such as banks and utilities. The expectation of any changes in future earnings is a primary driving force in determining the appeal of equities.
In theory, this accepted relationship would always hold true, if all other market forces were held constant. But since rate changes can be symptomatic of other underlying factors that impact the direction of equity earnings, it begs the question, “When does the basic interest rate to equity relationship not apply?” And in regard to the current market, “What should one expect for the equity markets when rates begin to rise from the current extremely low levels?”
For example, we have strong historical evidence of the negative impact that deflation (which is accompanied by a collapse in interest rates) has on equity markets. We have the 1930’s depression era as our primary data point, and even as recently as the last decade, we watched the Federal Reserve lower rates to near zero in both 2001 and 2008, long before stocks were able to eventually find a bottom and reverse course. If we accept that “rates very low and declining” are often symptomatic of a deflationary scenario and not necessarily bullish for stocks, then doesn’t it beg the question that “rates very low and rising” might often be bullish? Especially, if the rise in low rates indicates a move from deflation to more normal economic growth.
Impact of Interest Rates on Future Equity Prices
I’m going to avoid getting into the selection of which interest rate along the yield curve is the most important to equity prices and simply use what I refer to as the average interest rate (AIR), which I choose to define as the average of the 3 Month Treasury Bill, 5 Year Treasury Note and 30 Year Treasury Bond.
I defined the direction of interest rates as either one of three categories, rising, declining, or unchanged. The definition of rising interest rates was any six month period in which there was a 10% change in the AIR. For example, if AIR was 5%, then a six month change of more than 0.5% would define either a rising or declining period. A 10% AIR would require a six month change of 1.0% to define a rising or declining period. Rate changes less than this requirement fail into our unchanged rates category.
This may seem a little unnecessarily complicated, but I found that it improved the quality of the results, since 1% moves in rates are much more common when rates are in double digits than when they are below 5%. The study was done on the daily interest data that I currently have access too going back to 1970.
The Table below shows the impact that the “direction of interest rates” have had on equity prices since 1970. As you can see from the first column, being in the market only during periods of declining rates, one could have experienced a 16.31% return in equities, which is twice the 8% average annual return. When rates were rising, the market averaged a modest negative return (-0.91%). The crux of the study is in the last two columns where I separated S&P 500 return vs. the interest rate trend into two categories, days that rates were below 5% and days where rates were above 5%.
As we surmised might be the case, “low rates and rising” has been a positive category for stocks, averaging 13.21% on those days. Note that when rates were above 5% and declining, the average return has actually been 22.89%. As you would expect, “high rates and rising” is the worst monetary environment for stocks with an average loss of 5.07%.
Impact of the Level of Rates on Equity Prices
Although, not the primary purpose of my study, I was able to make an observation concerning the general impact of the level of interest rates on equity prices (irregardless of the interest rate trend). I divided interest rates into three groups that were approximately equal in historical occurrence. AIR below 5.0% was considered low, above 7.5% was considered high, and anything in between was considered medium. The table below shows how the market performed in each of the three categories.
Interest Rate Study Summary
- I found that the level of interest rates has some modest impact on the direction of equity prices, but is not nearly as significant as the direction of interest rates. However, medium (5-7.5%) rate periods were observed to have offered twice the returns of either low or high interest rate periods, suggesting that the markets prefers modest inflationary periods.
- As a general rule, a trend of lower interest rates leads to substantially higher equity prices and higher rates leads to muted and sometimes negative performance.
- The study data suggest that if interest rates are extremely low (which can often coincide with recessionary or deflationary scenarios), signs of economic growth is usually well received by the equity markets, even if it is accompanied by higher interest rates.
- Although not addressed in the study, the degree of change in interest rates is important. On those days where rates were high (AIR>7.5) and rising “very” fast (6 mt change > 1.0), the S&P was down on average 7.0% annually.
- 5. Over the last 40 years, you would have experienced a 19.3% return by being invested only in the 9.7 years in which interest rates were doing one of the following:
- AIR above 5.0% and declining or
- AIR below 5.0% and rising
Conclusion & Relevance to Today’s Market
The bullish “low rates and rising” results that we observed would be more convincing if we had more data points to draw from, but the results have intuitive appeal to me as well. The study only went back to 1970 for which I currently have daily interest rate data, but I have also recently found that Robert Shiller has 10 year treasury note yields listed on a monthly basis.
I was able to make the following additional observations, concerning “low rates and rising” on data prior to 1970. From the end of 1962 to the end of 1968, the 10 year note yield rose from the low level of 3.86% to 6.03%, while the S&P rose 106.5%. From the end of 1949 to the end of 1958, the 10 year yield rose slowly from 2.32% to 3.86%, while the S&P rose 223%. As for additional data on “low rates and declining”, at the close of 1928, the 10 year note was 3.58 and declined steadily throughout the next decade to a low of 1.97% at the end of 1940. During that same period of declining rates, the S&P lost 54.5%. When rates are extremely low, traditional interest rate trading rules appear to be suspect.
I am not making any predictions on the direction of interest rates, but in regard to the current interest rate implications for the market, I am of the opinion that “if” interest rates rise over the next year, equities will fare better than most anticipate, at least through the first couple rounds of hikes. My instincts are also that it is most likely imperative for the continuation of the upward move in equity prices that rates do rise at least modestly as I also expect that the most ominous interest rate scenario for equities would be a situation where short term rates stay near the current rates of zero (as the Federal Reserve has promised), and long term rates confirm the Feds deflationary concerns by contracting from the current +4% levels to below 3% as the prospects for economic growth diminishes and the odds of deflation increases. Recall that during the 08 crisis, 30 yr bonds got as low as 2.55.
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