Should Stock Investors Worry About Rising Rates?

The Federal Reserve meets this week and is expected to raise interest rates again. If they do, this will mark the third increase since December 2015, when the Fed raised rates following seven years at near-zero coming out of the Financial Crisis. An increase this week would likely bring short-term rates to 1-1.25%.

The last time the Fed embarked on a series of rate hikes was about this time in June 2004. Starting then, and over the next two years, short-term rates were steadily raised 17 times, adding 4.25% to what at the time had been 1% short-term rates. Rates stayed static until the fall of 2007, when the Fed began lowering rates more and more aggressively responding to what would become the Great Recession.

The recent rate increases, although fairly slow so far, ripple throughout the bond market and economy, with impacts that are mixed depending on your perspective. For example, yield-starved savers eventually eek out higher returns on cash accounts. But current bondholders can see bond prices fall a bit as rates rise. Individuals and businesses who borrow money have to do so at higher interest rates. For these and other reasons, the interest rate conversation tends to focus on the bond market.

But how about the stock market? Should stock investors worry about increasing interest rates? Do they foretell anything useful? If you knew in advance what the Fed was likely to do, or, for example, if your crystal ball told you exactly where the 10yr Treasury yield would be in the future, what could you do with that information? How easy would it be to profit from it?

The following article from Dimensional Funds addresses these questions (emphasis mine)...

Research shows that, like stock prices, changes in interest rates and bond prices are largely unpredictable. It follows that an investment strategy based upon attempting to exploit these sorts of changes isn't likely to be a fruitful endeavor. Despite the unpredictable nature of interest rate changes, investors may still be curious about what might happen to stocks if interest rates go up.

Unlike bond prices, which tend to go down when yields go up, stock prices might rise or fall with changes in interest rates. For stocks, it can go either way because a stock's price depends on both future cash flows to investors and the discount rate (required rate of return) they apply to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the stock to fall. However, it is also possible that when interest rates change, expectations about future cash flows expected from holding a stock also change. So, if theory doesn't tell us what the overall effect should be, the next question is what does the data say?

Recent research performed by Dimensional Fund Advisors (DFA) helps provide insight into this question. The research examines the correlation between monthly US stock returns and changes in interest rates. Exhibit 1 shows that while there is a lot of noise in stock returns and no clear pattern, not much of that variation appears to be related to changes in the effective federal funds rate.

Exhibit 1. Monthly US Stock Returns against Monthly Changes in Effective Federal Funds Rate, August 1954–December 2016

Monthly US stock returns are defined as the monthly return of the Fama/French Total US Market Index and are compared to contemporaneous monthly changes in the effective federal funds rate. Bond yield changes are obtained from the Federal Reserve Bank of St. Louis.

For example, in months when the federal funds rate rose, stock returns were as low as –15.56% and as high as 14.27%. In months when rates fell, returns ranged from –22.41% to 16.52%. Given that there are many other interest rates besides just the federal funds rate, DFA also examined longer-term interest rates and found similar results.

So, to address our initial question: when rates go up, do stock prices go down? The answer is yes, but only about 40% of the time. In the remaining 60% of months, stock returns were positive. This split between positive and negative returns was about the same when examining all months, not just those in which rates went up. In other words, there is not a clear link between stock returns and interest rate changes.

There's no evidence that investors can reliably predict changes in interest rates. Even with perfect knowledge of what will happen with future interest rate changes, this information provides little guidance about subsequent stock returns. Instead, staying invested and avoiding the temptation to make changes based on short-term predictions may increase the likelihood of consistently capturing what the stock market has to offer.

Have questions? Ask me. I can help.