Interest Rates and Stocks

With the final Federal Reserve meeting of the year, we share our thoughts on interest rates and the role they play in the stock market right now…

One of the most often discussed relationships in financial markets it the relationship between interest rates and the stock market.

It is a complicated relationship that is difficult for investors to understand.

The most significant difficulty is that the relationship CHANGES.

How stocks react to movements in interest rates can depend on many factors. Two of the main factors are where we are in the economic cycle and current investor expectations.

There are also big differences in the kinds of moves we see in interest rates. Size and speed matter in terms of the impact on the stock market.

We have seen the stock market move sideways in the last week or so.

This has coincided with an upward movement in interest rates. Are these two moves correlated?

Let's examine the movement in interest rates. Here is a chart of the recent yields on the US government benchmark ten-year bond…

The yield has increased from 3.6% to 4.2% since the middle of September, as shown at the end of the chart.

Critics see this as a very bad sign, especially after the Federal Reserve Bank had just cut interest rates. Some say it is a sign of the collapse of confidence in the US dollar and the US government’s ability to borrow money.

We point out that interest rates are back to where they were in July. This is NOT a big deal.

The move is just not that big. At the start of the year, yields went from 3.8% to almost 4.8%. Do you know what the stock market did during that period? It soared!

This is where the size and speed of a move make a difference.

Let’s take a look at the chart of this yield across the last five years…

Look at the size of this most recent move. It doesn’t even show up on the chart.

The fact is that this size of move really doesn’t mean anything for stocks.

In fact, our argument has been supported by the absolute level of interest rates in recent years—the higher rates also have not mattered very much.

Whether rates are at 2% or 5%, it's not that big of an economic impact.

It would be a much bigger issue if we were talking about 10%, 15%, or even 20%. Those were the kinds of levels that we saw back in the 1970s and 1980s, and they had a major impact on the economy and stocks.

Rates were high enough—and the changes in them impactful enough—that they could put companies out of business. A move from 5% to 15% is a BIG move. A move from 2% to 4% is NOT.

In 2022, though, interest rates DID matter to the economy and stock market. If absolute rates and the move in rates were both low, why did they still have an impact?

The answer is the VELOCITY—the speed of the move.

Most companies didn't care about interest rates at 1% or 5% as the impact on their business was minimal.

That rate movement, though, happened in just a little bit more than a year. THIS was difficult for companies to digest.

Again, they didn't care about the low rates, but they did care as they moved. Planning out your business operations is hard when the rates are moving so quickly.

You can see this in the action of stocks.

Here is a chart of the yield of the 10-year government bond along with the price of the S&P 500…

In red, we highlight the period when bond yields were moving higher rapidly.

The stock market sold off during this period. Companies had trouble adjusting to rapidly changing interest rates, and earnings estimates saw negative revisions.

Once the rates STOPPED going up as rapidly, though, and reached some stability (the green), the stock market found its footing and moved higher.

In fact, the first rate peak occurred in October 2022, which also marked the bottom and the start of the current BULL market.

This chart shows that interest rates CAN matter to the stock market. We just don’t think that they matter much right now…