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What Do Rates Rising from Zero Mean for Equities? at Trader’s Narrative





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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%.
S&P500 returns vs interest rate direction table 1
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.

impact of interest rates on equities table 2

Interest Rate Study Summary

  1. 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.
  2. 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.
  3. 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.
  4. 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. 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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16 Responses to “What Do Rates Rising from Zero Mean for Equities?”  

  1. 1 Patrick

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    Agreed, I mean 20 years of historical data can’t be wrong, right?

    However we should consider that the correlation might get bent a bit since the ponzi scheme of global currency is starting to break down for real this time, and that we may be stuck with low, near-zero interest rates for a while. Consider that the carry-trade could unwind from sheer profit taking with the USD rate still at 0, or that a 25 bps increase might have a disproportionately large negative impact on asset prices.

  2. 2 wayne

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    Patrick

    The study went back thru 1970 (40 years) for which I currently have daily interest rate data for the three interest bearing securities that I prefer to use in the studies, but I have in the last couple of days found that Robert Shiller has 10 year treasury note yields listed on a monthly basis on his internet site. I was able to make the following additional visual 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 slowly and steadily 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%.

    I believe that at a minimum, we can conclude that when rates are extremely low (Less than 3.0%) , traditional interest rate trading rules appear to be suspect.

    I am still in the process of working thru this.

  3. 3 Guy Lerner

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    That’s a good study; curious to know what would happen if you applied your studies to Japan (Nikkei and their bond market) — that would be a true test and might even be representative of what we might see going forward in this country

  4. 4 b.

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    Wayne,

    Thank you, very insightful article.

    It would be interesting to post a chart to show AIR with your definitions of the different modes, juxtaposed with the SP.

  5. 5 wayne

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    Mr. b., I really need to work on my charting skills. I was pretty good with Mac Draw & Cricket graph and then switched to PC a decade ago and skills have eroded. Mac was great for charting in those days. I found PC charting not as user friendly. or maybe it’s just hard to teach an old dog, new tricks. Maybe I could mail one of you guys the data and you could play around with it.

    Guy, Japan has been on my Todo list for the last decade. One of you well financed institutions should give me some motivation to study such ideas.

    My December Project is to come up with an “intuitively sound” trading strategy, based on above observations to incorporate into my current intermediate trading model and I’m making some progress.

    I was just studying another interesting twist on the output. Below is the average S&P performance since 1970, when AIR is declining, as a function of AIR level.

    AIR S&P Performance
    10.000, 37.63

    The trend in those numbers in undeniable. As you recall, An excellent time to be in stocks over the last 40 years was when rates were high and declining. (82-84), (74-75), (88-89). I wonder if we will see double digit rates again in this generation?

  6. 6 wayne

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    oops, the table in the last paragraph didnt make it thru, the last parag should have read,

    I was just studying another interesting twist on the output. Below is the average S&P performance since 1970, when AIR is declining, as a function of AIR level.

    ..AIR.. S&P % CH
    10.0, 37.63

    The trend in those numbers in undeniable. As you recall, An excellent time to be in stocks over the last 40 years was when rates were high and declining. (82-84), (74-75), (88-89). I wonder if we will see double digit rates again in this generation?

  7. 7 wayne

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    Dad gum it , These comment boxes are not table compatible. Try this

    …AIR.. S&P %Ch
    0.0-2.50 -9.99
    2.5-5.00 08.44
    5.0-7.50 18.51
    7.5-10.0 25.75
    GT 10.00 37.63

  8. 8 b.

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    Hi Wayne,

    Thanks for your input!

    I am wiling to try and chart it in excel if you want to send me the data. My email is trich_b@yahoo.com

    Best -

  9. 9 Samuel

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    You should really try and review Hoisington Asset Management’s analysis of the interest rate scenario for the next 15 years. They think it is most likely to be similar to the 1930s scenario and the Post Japan 1990 scenario. The period of postwar America from 1940 to 2008 was one of a slowly building debt bubble. This was especially the case for 1980 on through 2008, and this debt bubble has enormous implications for the behavior of interest rates. Interest rate activity breaks down when the credit system is broken and the system of ponzi finance reaches its apex.

    http://www.hoisingtonmgt.com/hoisington_economic_overview.html

  10. 10 Dave

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    I find looking at interest rates & earnings expectations helpful.
    (imagine quadrants)
    Falling rates & falling earnings expectations, eg. 2008, bad for stocks.
    Falling rates & rising earnings expectations, eg. 2009, good for stocks.
    Rising rates & rising earnings, eg. 2010, good for stocks.
    Rising rates & falling earnings expectations, eg. 2012?, bad for stocks.

  11. 11 Matt

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    It seems like an equally important layer are spreads. (ie. 10 yr. from 3 month). I would be interested in comparing results if:

    1. Rate is falling and Spreads are widening
    2. Rate is falling and Spreads are thinning
    3. Rate is rising and Spreads are widening
    4. Rate is rising and Spreads are thinning

    This would help discount some of the “it’s different now” comments.

  12. 12 wayne

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    Matt & Dave,

    I have been doing mathematical analysis of the markets since 85 and fulltime since 1993 when I retired from my engineering job. The more I learn, the more I realize how much more there is to know. My todo list is endlist and as a guy who likes to play with numbers, I feel fortunate to be afforded the opportunity to make a living doing market research and trading for a living. I try not to push my findings on anyone, but simply enjoy writing and don’t mind sharing some minor details of my research.

    Yield Curve relationship is a variable in my model and has been studied by many and recognized as an important ingredient in quantifying the future of equity prices. I simply didn’t choose to address it in this report.

    Interest rate direction is a variable I model as well and I wrote the above report to document some research I was doing that was going to result in some modifications of that indicator.

    Most models work well as long as they are within the historical bounds in which they were developed. Just as the early 80’s was a challenge with the unprecedented 15% interest rates, the current environment is equally unique in it’s low rates. We draw from the data we can find and try to add intuitive logic to our findings to make sure they are sound. That is why it is important that models always rely to a large degree on staying in line with tape and risk management. Models rarely work going forward as well as they did in the period they were optimized over. Going into 1997, the market had a 100% historical record of being lower a year later whenever the dividend yield was less than 3%, yet we doubled in the next 3 years. We evolve.

    I wish I knew of one single indicator that was infallible in predicting future market direction but one does not exist. And even if it did, as soon as it was discovered and advertised as such, it would lose it’s predictive ability. The market will, by it’s nature, always be a moving target. That’s is one of the factors that makes it intriguing phenomena to observe and study.

    My interest rates studies led to the following observations

    1. Rates between 4-6% “tend” to be conducive to higher equity prices. The further you get from those levels, the less friendly the market becomes.
    2. When rates are above 6%, rising rates “tend” to be negative for equities and vice versa.
    3. When rates are below 4%, rising rates “tend” to be positive for equities and vice versa.
    4. The further rates get from 5%, the more exacerbated the impact of 2 & 3 above become.

    Aria & Jeremy,
    If your not interested in the studies presented at this site, don’t let the door hit you in the ass on the way out. You received more than your money’s worth for your time here.

  13. 13 wayne

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    I have been reading a few analyst outlook for 2010 and many mention a concern about the prospects for higher rates in 2010.

    I had in the last couple of months, done a study “What do Interest Rates Rising from Zero Mean for Equities”, but these comments motivated me to try to dig a little deeper. I found the following web site, that showed all the changes in the Discount Rate and Federal Reserve Rates going back to 1970.

    http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

    I was interested in looking at all cases where Fed Rates had been in a downtrend and were very low (

  14. 14 wayne

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    I have read several analyst outlook for 2010 in the last week and many mention a concern about the prospects for higher rates in 2010.

    I had in the last couple of months, done a study “What do Interest Rates Rising from Zero Mean for Equities”, but these comments motivated me to try to dig a little deeper. I found the following web site, that showed all the changes in the Discount Rate and Federal Reserve Rates going back to 1970.

    I was interested in looking at all cases where Fed Rates had been in a downtrend and were very low (<5.0) and were then raised for the first time, reversing the trend. Since some of the federal funds changes were listed as gradual events over several days, I focused on the discount rate, which is a more overt move on the Fed's part and easier to associate with a certain date. Although it tends to lag the Fed funds rate, that is ok, since this is a longer term time frame study, anyway. I found four occasions that met my criteria, and the results supported my original research thesis, that low rates and rising are not as negative for equities as most anticipate.

    wayne interest rate comment Dec 2009

    The results would be more persuasive, if I had more discount rate data points closer to zero, but this is the best we have. The closest comparison we would have is 2002-2004. Although there are of course major differences, but from an SP trend and interest rate perspective, the end of 2003 looks very similar to 2009 to me. At the end of 03, we were 15 months from the market bottom set October 9, 2002, that had followed a 28 month sell off that was 49% in magnitude. At the end of 03, the 3 month treasury bill was yielding 0.91% and the 30 year bond was 5.07% resulting in an abnormally wide 4.16 spread, all somewhat similar to today. The market was up a respectable 9% in 2004, and although I acknowledge that we are further off the bottom than at the end of 03, we also had positive years in 05, 06 and 07 on our way to retesting the old highs.

    I am increasingly of the opinion that the worse case interest scenario for equities would be a collapse of long term rates (short term rates seem to have found support at zero) and that a slow increase in short term rates over a 24 month period will not damage the markets, but may actually be conducive, especially if it is in response to improving economic conditions.

  15. 15 wayne

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    Babak, I didn’t mean to create so much work for you, but the table above was there a moment ago and now disappeared. I trust you are brushing it up.

  16. 16 Babak

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    Wayne, no worries - it should be up now, let me know if you can’t see it

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