Interest Rates Move Stocks

In the June 2007 we saw longer term interest rates with the 10 year U.S. Treasury Note breaking up through the 5% level. In response to the most recent rise in interest rates, stock price volatility increased causing investors to become more cautious about the stocks in their portfolios. The question is does this increase in interest rates signal a decline in the stock markets and in the price of stocks? Before answering that question, consider some background on interest rates.

Who is in the Driver’s Seat, Interest Rates or Stock Prices

What affect does interest rates and bond prices have on stock markets and the prices of stocks? Basically, bond investors are more closely aligned with the economy as interest rates are a key determinant of economic performance. Stock investors must be aware of the economy but they focus on companies and their individual performance.

Interest rates and especially changes in interest rates are a major driver of the economy and the stock market. As investors we are very interested in the direction interest rates will go over the next 6 months and year. Unfortunately forecasting the direction interest rates will move is fraught with failure. Typically, for every forecast of increasing rates by economists there is another forecast of decreasing rates. So what are investors to do?

Well, it turns out that interest rates are much more volatile that most investors realize. Ed Easterling of Crestmont Research found out that in the past 35 years (with a 2-month exception), there has not been a 6-month period during which interest rates somewhere along the yield curve did not change at least 50 basis points. More than half of the time, interest rates change by more than 1.5% (and over 25% in percentage terms) over all 6-month periods. Now that is something we can use, so let’s examine the current state of interest rates in a little more detail.

State of Interest Rates

Bill Gross of Pimco Bonds, the world’s largest bond management firm, stated in his most recent investment outlook that “With the possibility of creeping inflationary tendencies, especially in weak currency countries including the U.S., combined with the potential reduction of financial flow subsidies which to this point have favored fixed income vs. equity and real commodity investments, we come to the following range forecasts for the secular timeframe from 2007 to 2011.”

Source: Pimco Bonds Investment Outlook May/June 2007

While not the only cause of the rise in the 10 year U.S. Treasury rate, Bill’s comments are closely followed. Rising rates are further evidence that the Federal Reserve will not be lowering rates in the next six months.

The chart below shows the 24 year bull market in 30 year US treasury Bonds. This is the chart of bond prices not interest rates. Remember bond prices move in opposite direction to interest rates. As indicated, it looks like this could be coming to an end. If this happens then Bill Gross’s comments would be confirmed and we are much more likely entering a period of higher rates.

The chart below is of the 10 Year US Treasury Yield. It shows that rates are rising and testing resistance levels. On the chart the 5.25 and the 5.44 areas are important near term resistance. In addition the high of the last ten years is quite close to the target mentioned by Bill Gross. Kind of interesting.

What Stock Investors Should do Now

So what does this mean for stock investors today? First, we need to assume that interest rates are more likely to move up than down for now. That means that companies that are more sensitive to rising interest rates should be avoided, such as REITs and utilities.

In theory, rising interest rates should be good for stocks. If the economy is growing too rapidly then corporate earnings should also be growing rapidly and so should stock prices. In reality, rising rates are often bad for stocks, for several reasons:

·         When rates go up, investors who had been buying stocks opt for bonds because their yields are rising.

·         The market looks ahead. Stocks rise when investors think the economy and corporate earnings will grow. When the Federal Reserve increases rates, it is seeking to restrain the economy.

·         Companies that borrow money pay more when interest rates go up. This reduces their earnings.

·         Consumers also pay more to borrow money, which discourages them from buying cars, houses and everything that goes with them. This hurts companies dependent on the consumer.

As a result stock investors need to become slightly more cautious keeping an eye on changes in interest rates. It does not mean that we should avoid stocks. It just means we need to recognize the impact higher rates will have on the U.S. and global economy and corporate growth. Companies that can fund growth with less debt should benefit.