Rising Interest Rates Aren't Always Negative for Stocks

It seems intuitive and the markets always seem to react as if rising rates are negative for equities and declining rates are positive for equities. As usual with the stock market, simple thinking can burn you very fast. The market is much more complex then just "Don't Fight the Fed".

Go back to 2008 and question that thesis. Rates were declining and stocks were getting crushed. Why? Well its because even though the interest rate direction has an impact on the economy it takes a long time of up to 12 months for the impact to be felt. When the Fed is lowering rates from an already low level it signals distress which leads to panic in the markets. Did the Fed lower the fed funds rate from 2% to 1% because it wanted to juice the recovery or because they feared the Great Depression II?

The announcement by the Fed last Thursday night after markets closed that they were raising the discount rate to 0.75% from 0.50% nearly sent panic around the world. That is until the US markets opened and stocks were back in the green. Why? First, the discount rate still trades below the normal 1% premium. Second, it really has no impact on consumer loans and hence the economy. The fed funds rate is the important rate and it isn't about to be raised. Testimony today before Congress backs that up.

So back to what an investor should do in a rising rate environment. If the fed funds rate is raised from 0.25% to 0.5% or even 2% should you sell stocks? The conventional wisdom is that you should run screaming from all risky assets including stocks. Well, this study at Trader's Narravtive suggests that the level of the interest rate is just as important as the direction. After all, you need to think about what the rate direction + level does to consumer and even corporate loan and investment appetites.

If rates are extremely low and you know they are going higher it might just push companies financings forward. If you want to buy a house and you know rates are going 2% higher, would you buy now or wait? Would you delay a financing for $1B that could be done at 6% today versus 8% next year? On the converse side, if the fed funds rate is say 6% and your talking about corporate rates above 10% and getting higher your likely to not even consider a loan. So the direction has a huge impact on borrowing patterns and hence the business cycle. One pulls them forward and one delays indefinitely.

This is possibly one of the best reports I've seen. The 2 best times to invest in stocks is when rates are low and rising (against wisdom) and rates are high and declining (common wisdom). In general, its clear that the best time to buy stocks is during a declining rate environment or even unchanged like over the last year though the future rate direction could be considered here. Both 2001 and 2008 taught us that buying when rates are low and declining very fast can be painful.



This study uses Treasury yields versus the fed funds rate, but its still the same theory. The major difference is that the Fed Funds rate remains unchanged for ate 6 weeks at a time while the Treasury yields can rise and drop on a daily basis. He makes another important distinction about the pace of the rate of change. He uses a > then 1% change in the interest rates having a much greater impact. A signal that low rates and a slow decline can be bullish meaning only the periods where rates are low and declining fast are equities hammered ala 2001 and 2008. So its possible that low rates are bullish unless its a panic scenario where rates drop extremely fast.

Whats also not incorporated into this report is the yield curve. Its ultimately been shown that a high yield curve is bullish for the economy and a low or especially negative yield curve kills off the economy. This would probably roll right into the results of this study. We're seen over the last 2 years that even when the yield curve is bullish that the direction of the yield curve has an impact. When the yield curve is bullish and dropping the market is positive. When the yield curve is bearish and rising the market is negative. This last fact matches up with the 2001 and 2008 periods where dropping rates lead to a much more positive yield curve but stocks sold off. Need to do more work on this to be more conclusive.

This last statement from the report highlights my theory the best:

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

Yield Curve, Yield Curve, Yield Curve

As we've touched on several times in the past, the Yield Curve or the difference between the 10 Yr Treasury and the 90 Day is very predictive of future economic growth. A wide difference in yields of 2% of more is usually very conducive to growth while a flat to negative yield curve signals tough times ahead - credit is restricted at those levels.

Bloomberg had an article today about the Yield Curve being the highest since 1992. Now they use the difference between the 30 Yr and the 2 Yr securities, but it's still the same philosophy with different versions of long term versus short term yields.

No matter which version you use, when the Yield Curve is 368 basis points banks are literally printing money by borrowing it for next to nothing and lending it at much higher rates. Just think how your savings account pays next to nothing, but a 30 year mortgage is around 5%. One major problem though is that banks are having a hard time finding qualified borrowers of that cheap cash. As the economy begins to recover that issue will be worked off. Count on the Yield Curve remaining high until those problems are solved though which is one of the major backstops for the economy and market.

• Treasuries fell, with the gap in yields between 2- and 30-year securities near the widest margin in 17 years, before today’s $13 billion bond auction.

• The so-called yield curve touched 368 basis points, one basis point below the 369 level it reached in 1992, with the Federal Reserve’s target rate anchored at a record-low range of zero to 0.25 percent and the Treasury extending the average maturity of government debt being sold. The shift to longer- maturity debt has raised concern that investors will demand higher yields to offset the risk of inflation as government spending drives the deficit to a record $1.4 trillion.

• The “historically wide slope” between 2- and 30-year debt “should help entice investors and arbitrageurs to consider bidding for today’s supply against shorter issues on the curve,” Chris Ahrens, head of interest-rate strategy in Stamford, Connecticut at UBS AG, wrote in a note to clients.

Edit - after the close: Just noticed that the closing Yield Curve jumped to a 29 year high of 373 basis points. This weakness explains why risky assets such as the Russell 2000 stocks have been weak lately. Some flight to quality or large cap stocks is taking place. Oddly though, this yield curve is most bullish for small caps and risky assets. Ideally you buy them when the yield curve is high and sell them when its flat.

• Treasuries fell, with the gap in yields between 2- and 30-year securities reaching the widest margin since at least 1980, after a $13 billion offering of 30- year bonds drew lower-than-forecast demand.
• The so-called yield curve touched 373 basis points, the most in at least 29 years, as the bonds drew a yield of 4.52 percent, compared with an average forecast of 4.483 percent in a Bloomberg News survey of five of the Federal Reserve’s 18 primary dealers. The so-called yield curve has widened from 191 basis points at the end of 2008, with the Fed anchoring its target rate at a record-low range of zero to 0.25 percent and the Treasury extending the average maturity of U.S. debt.

The Ultimate Leading Indicator: Yield Curve

As we've been fond of pointing out this year, the leading indicators tell us where the market is going. A lot of investors have fought the trend by concentrating on lagging jobs reports or focusing on future write downs at banks. Those are all concerns, but the leading indicators have told us for months that the future is bright.

One of the best leading indicators around is the Yield Curve. Unlike most indicators whether leading or lagging this one can be followed on a daily basis and doesn't rely on random sampling or questionable government reports. The old addage of don't fight the fed is alive and well. As the chart below shows, when the Yield Curve is above 3% or the difference between the 10 yr and 90 day Treasury bills yields that is the time to buy stocks. Conversely, when the yield flattens out and becomes flat is the time to sell stocks. The negative yields in both 2000 and 2007 were huge warning signs of impending problems.

One interesting note going back to the addage of not fighting the fed. It's usually been portrayed that you shouldn't fight the Fed from day 1 of a change in rate policy. Instead its usually not until the Feds policies change the economic situation up to a year later that you should be concerned.

As we know all to well from 2007/2008 is that even while the Fed cut interest rates sending the yield curve soaring up, the market kept plummeting. Similar to what happened in 2000. The reverse happened in 2004 when the Fed started tightening or increasing rates, but the market kept going up for a couple of years. Ultimately the yield curve became negative and most domestic related stocks hit their peaks in 2006. It was only because of commodity stocks and emerging market growth that major markets peaked in 2007.

Back to today, the yield curve is hanging strong over 3.4% providing huge incentives for the economy to expand. For everybody expecting the impending correction, this indicator suggests it isn't going to happen. In fact, it won't be until nearly a year after the Fed starts raising rates that the economy will suffer and hence stocks should be sold. So many people seem to fear the first rate increase, but instead that's a sign to remain bullish. The Fed Funds Rate going from 0.25% to 0.50% isn't going to derail this economy. Mainly because the following economic reports will be strong making people confident that the higher rates aren't having an impact. Then wham, after the 10th raise in 12 months, the economy will finally stall.

If anything, this leads us to the ultimate issue with the Fed playing yo-yo with interest rates. It takes 12 months for rate changes to impact the economy and yet the Fed decides to make drastic changes within 6-9 month periods. Almost like a kid that embarks on a 12 hour drive and wants to know if we're there yet after 2 hours.

This behavior in Fed policy and the havoc is has on the economy is one reason the 'buy and hold' strategy hasn't worked very well this decade. So many experts claim that the strategy is dead, but we maintain that depends on the Fed and what the Yield Curve tells us. Forget the forecasting, just let the indicators tell you what to do next. For now, they say stay long risky assets.






Note: Our first mention of the hugely positive Yield Curve was on Nov 17th. Basically when most stocks hit bottom. The market made a lower low in March, but the average stock didn't.

Stat of the Day: Off the Charts Yield Curve

Another indication of the whackiness in this market. The yield curve is now off the charts bullish. This usually has a very positive impact on future bank earnings, but in a market where lending is limited its difficult to determine if the impact will be like normal cycles. Typically banks are encouraged to lend like crazy because the spread is so positive for them, but that isn't happening this time because of the financial crisis. You can bet though at some point in the future, this yield curve will help return the market to growth and inflation. In fact, its likely to cause irrational investments as it always does at the peaks and troughs.

This number is off the charts because of the huge compression in the rates of the T-bill. Its unlike anything the market as seen even in the last 25 years. Anytime this ratio gets above 2 it becomes very bullish for the future economy. The markets tend to forget that in periods of extreme bullishness or negativity that such monetary realities will cause a dramatic shift in the future economies direction.