Wednesday, February 24, 2010

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

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