Over the past two years, the Federal Open Market Committee (FOMC) has slowly been raising the target range for the Federal Funds rate from 0.0% – 0.25% to 1.00% – 1.25%. The most recent change in the target range was on June 14, 2017. They also met this past week, but as expected, no changes were announced.
These changes, of course, are the Fed’s attempt to try and keep the economy from growing too fast, which could create an undesirable level of inflation. To maintain a healthy economy, a small amount of inflation is good and necessary—large increases in inflation, however, can lead to all sorts of problems. High inflation creates uncertainty and erodes the value of savings. It creates artificial demand because people will spend all their money today if they think that goods will be significantly more expensive tomorrow.
Since interest rates are the cost of money, one might argue that higher rates will lead to lower profits for those companies that borrow money to operate. And if interest rates have been rising for the past two years, why are corporate profits still advancing? Is this unusual? Are investors being foolish for continuing to invest in stocks today?
Not at all. While there have been times when the adage, “Don’t fight the Fed” rang true, the research shows that changes in interest rates are extremely unpredictable. Furthermore, the relationship between interest rates and stock prices is very “noisy” when you examine the data.
Current interest rates, bond prices, and stock prices all reflect the aggregate expectations of market participants. Therefore, trying to forecast stock prices based on the future direction of interest rates assumes that nothing else matters, which of course, is silly. The price of a stock depends on the following:
- What the company owns minus what the company owes
- What the company will earn in the future, and the discount rate applied to that future earnings stream
All other things held constant, when interest rates rise, the discount rate will increase, and the value of the company should fall. However, in real life, the discount rate is not the only variable. Higher rates might be an indication that the economy is growing faster than expected, which might cause future profits to be higher than expected, offsetting the negative impact of a higher discount rate.
Empirically, we looked at stock and bond market data going back to 1954, and compared the monthly returns of the stock market to contemporaneous changes in bond yields. When viewing the data in scatter plot form, one can easily see that there is no discernable relationship between equity returns and changes in interest rates. Using the federal funds rate as one example, in months when rates rose, stock returns were as high as 14.3% and as low as minus 15.6%. In months when rates fell, stock returns were as high as 16.5% and as low as minus 22.4%. A similar result occurred when comparing stock returns to 1-year, 5-year, and 10-year U.S. Treasury obligations as well.
So, what are the main takeaways for investors? Theoretically, there is no reason to expect a causal relationship between interest rates and stock prices—too many variables are involved. Empirically, the historical relationship between the two has been weak and noisy. Based on personal experience, we can certainly remember times when interest rates jumped unexpectedly and the stock market declined immediately in response. That makes sense—the market hates uncertainty. The key, however, is that one never knows in advance when an unexpected event is going to occur. The more intelligent course is to stay invested. Once you have established a prudent emergency fund, don’t allow fear or pride to keep your assets on the sideline. You can’t win if you don’t stay in the game.