These days a lot of macro discussions are focusing on rising interest rates. Will the Fed taper? When will they taper (seemingly next week)? And what will happen to markets when they do, in particular what will happen to equities?
Conventional wisdom says that rising rates are bad for equities. There are lots of justifications of this claim the main one (that we like and think makes sense) is that rising rates mean a higher “risk-free” rate which means higher interest rates on fixed income products from savings accounts to 30-year bonds (yield curve assumptions aside). Ultimately, the qualitative thought behind this argument is that as rates rise the average Joe will see higher yields in fixed income products and will opt to put more of his money into some kind of interest bearing account (savings, money market, CDs, notes, bonds, etc.). When that excess capital goes into the various interest bearing vehicles, the money will have to come out of whatever vehicles it was parked in. Conventionally, the thought is the money will come out of equities thus lowering stock market returns. This, of course, makes logical sense, if I can get a high yield with “no risk” why risk the volatility inherent in the stock market, especially against the often frightening macro backdrop offered these days. At the same time, higher yields will incentivize Joe to save not spend thus impacting the economy in a negative way.
However, despite this completely logical argument, we can make a counter claim, which is equally logical and convincing. The claim would be that if the Fed does taper and rates rise that means things are on the mend in the economy and that means companies are doing better and things are otherwise getting better. So if things are getting better we should probably expect equity markets to keep marching up indefinitely-better economy means better things for the companies which make up said economy means better sales>earnings>valuations.
While each of these arguments is compelling and could be used to justify action, we prefer to find out what lessons history tells, in particular what historical data tell us about the relationship and what we might expect going forward based on historical outcomes.
We examined monthly data on 2 and 10-year yields and the S&P 500 (SPY). We calculated simple percentage change returns, comparing this month’s S&P 500 return to last month’s 2 and 10-year yield change. We did this because we were trying to determine what happens to stock returns after rates rise. In order to determine what happened “after” rate changes historically, we would have to see what happened to the S&P 500 the month after the various rate changes. Below are two charts, which show the scatter diagram relationship including a simple linear regression line.
(click to enlarge)
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