Rates Are Rising, Rates Are Rising

Wednesday, August 28, 2013, Vol. 128, No. 168

On July 22, 1981, the federal funds rate (the interbank overnight benchmark rate) hit a historic high of 22.36 percent. On Dec. 11, 2011, it bottomed at .04 percent. Between 1981 and today, large company stocks returned nearly 11 percent on an annualized basis. As consensus suggests, falling interest rates undoubtedly make stocks more valuable.

While today’s rates may remain historically low for an extended period, their absolute lows have most likely been printed. The Federal Reserve has pegged the overnight rate at 0 percent and suppressed long-term rates by purchasing $85 billion a month of long-duration Treasuries and mortgages. We now seem to be entering the phase where this policy may reverse.

The mere suggestion of a turnabout has led to rising rates. Yes, the overnight federal funds rate remains anchored at 0 percent, but the 10-year Treasury has climbed from 1.43 percent to 2.84 percent. Will rising rates lead to falling stocks? The historic correlation between intermediate term bond yields and the S&P 500 is slightly negative. This implies that an uptick in yields leads to a decline in stock values. Case closed? Not so fast.

Peering deeper into the relationship between stocks and bond yields, we find that if rates rise on rising economic expectations, stocks and yield correlations are positive, but if rates rise on rising inflationary expectations, correlations turn negative. To translate, as yields rise off their lows in an economic recovery, stocks tend to perform well. Once inflationary pressures build and yields climb to more punitive levels, stocks tend to struggle with competition, anticipation of earnings pressure, and threat of economic recession.

Recent observations add confirmation. Between 1/1/09 and 12/31/09, the 10-year Treasury yield increased by 1.65 percent to 3.85 percent; simultaneously, the S&P 500 gained 26.46 percent. Between 9/1/10 and 3/31/11, yields increased by 1.00 percent to 3.47 percent; simultaneously, the S&P 500 gained 27.78 percent. Finally, between 7/25/12 and last week, yields increased by 1.47 percent to 2.9 percent; simultaneously, the S&P 500 gained roughly 30 percent.

When interest rates and stock prices rise in tandem the returns can be substantial. In fact, according to research done by the Leuthold Group, there have been 12 distinct incidents since 1955 when yields and stock prices rose together. The average yield increase was 1.69 percent during these episodes, while the average stock index increase was 35.3 percent.

Does that mean that we could count on another 30 percent gain if rates rise further from here? Unfortunately not, when yields climb above 3 percent, correlations become less meaningful until rates rise above 5-6 percent, when they turn decisively negative.

So the frequent arguments you hear that rising rates equals falling stocks prove false. Stocks did return 11 percent annually between 1981 and 2013 as Treasury rates collapsed, but they also returned 10.4 percent between 1954 and 1981 as Treasury rates soared.

With inflation low and economic growth escalating, rising rates should correlate with rising stock prices. Eventually, when inflation escalates and economic growth stagnates, rising rates will negatively correlate with stock returns. While the stock market may fall from here … please don’t blame interest rates rising on economic optimism.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.