Interest Rates

When Rates Go Up, Do Stocks Go Down?

Should stock investors worry about changes in interest rates? 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 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

Recent research performed by Dimensional Fund Advisors 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.

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, Dai 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.

CONCLUSION

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.

Treasury Market Absorbs Fed Increase

In our recent paper “Short-Term Rates on the Rise,” we discussed the increase in short-term interest rates that has been underway since 2013. We also posed a complex question: Has the market been leading the Fed to increase interest rates, or has the Fed been leading the market by setting expectations for the purpose of not surprising market participants?

Although we still do not know the answer, both scenarios may have led us to the same outcome experienced on December 16—a market that was unsurprised and able to digest, without a catastrophic loss, the first increase in the federal funds target rate since 2006. In fact, yields on US Treasuries ended the day relatively unchanged from the previous trading period and in some cases below their highs for the year.

The 6-Month US Treasury bill yield ended 3 basis points1 (bps) lower, the 1-Year US Treasury note 1 bps higher, and the 2-Year US Treasury note 4 bps higher.

The market’s ability to reflect the probability of different outcomes and events in security prices reinforces the greater importance of focusing on asset allocation and diversification as opposed to parsing information from “news” in an attempt to forecast future market activity.

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The Rise of Short-Term Interest Rates

While many market participants wait for the “inevitable” rise in short-term interest rates expected when the Federal Reserve tightens its monetary policy, some investors
may have missed the increase in short-term rates already underway as a result of market forces.

Looking at the zero- to two-year segment of the yield curve—the segment that many believe will be most affected whenever the Fed “normalizes interest rates”—it may be surprising to see how much rates have increased since 2013.

In fact, the yield on the 2-Year US Treasury note has nearly doubled since the beginning of 2015, rising from 0.45% in

January to almost 0.90% today.* The yield on the 1-Year US Treasury note has more than tripled, from 0.15% to more than 0.50% over the same period. The 6-Month US Treasury bill’s yield rose from a low of 0.03% in May to over 0.30% today. Yet, despite the higher rates, we have not experienced the conjectured financial storm in the fixed income market.

The question of when the Fed will raise its overnight target rate is still open. Similarly, we can ask ourselves a more complex question: Will the market lead the Fed or is the Fed leading the market through setting expectations?

Considering Central Bank Influence on Yields

Fed watching is a favorite pastime for many market participants. Investors read statements from the Federal Reserve as if they were tea leaves, parsing new information and seeking to forecast future Fed activity. The presumption is that Fed actions lead to specific market outcomes. Recently, some market prognosticators believed that the Fed was going to begin raising the federal funds target rate. However, what actually happened reinforced how difficult it is to accurately forecast when a Fed tightening cycle will occur or what its effects may be.

The presumption of many is that longer-term interest rates will rise when a tightening policy does begin. However, history shows that short- and long- term rates do not move in lockstep. There have been periods when the Fed aggressively lifted the fed funds target rate—the short-term rate controlled by the central bank—while longer-term rates did not change or “stubbornly” declined.

A good example is the Fed’s last campaign of policy tightening through the use of the fed funds target rate (see Exhibit 1). From 2004 to 2006, the Fed increased the rate by 4.25%, yet longer-term rates experienced a period of decline. Alan Greenspan, Fed chairman at the time, referred to this phenomenon as a “conundrum.”