Yesterday (February 25, 2020) was a tough one for the markets. The 10-year treasury jumped to a 1 year high of 1.6%, which caused the worst single-day selloff of stocks since October. The recent rise in interest rates has some investors worried, understandably. Thus, at the last minute I abandoned the newsletter I'd planned on sending out (which is mostly a satirical guide to attending free steak dinner seminars hosted by financial advisors) until next week, and replaced it with this commentary on interest rates.
If we've learned anything over the last 12 months (or 12 years, for that matter) it should be that a single day, week, month, or year shouldn't command our focus when it comes to the returns in our portfolios. What we should be focused on is the string of consecutive days, weeks, months, and years and how we can avoid making poor decisions amidst the onslaught of noise. However, sometimes we need to address a specific issue when dealing with that noise so that we can endure, stay on track, and thoughtfully pursue the outcomes we desire.
So, here we go:
Should stock investors worry about changes in interest rates?
Maybe. But before we get into stocks, let's just quickly refresh the relationship bonds have with interest rates (it will help us frame the argument when it comes to stocks):
Consider a hypothetical company, let's call it "XYZ", is borrowing from people this week by issuing bonds and promising to pay 3% interest over 10 years while the US Government is paying, let's say, 1.5% on 10 year treasury bonds. XYZ has to pay more than the US government because it's less creditworthy and the risk of being unable to pay back the funds is higher -- this is called the Credit Premium.
To help us amplify the argument, let's pretend the US raises the interest rate on 10 year treasuries all the way up to 3% next week (this kind of spike should never happen, but it helps make the point). So now you have a choice between two bonds which yield 3% for the next 10 years; one is issued by company XYZ and the other by the federal government. The demand for XYZ bonds would fall because there is no compensation to the investor for taking the additional credit risk through loaning funds to a company rather than the federal government. As the price of XYZ bonds fall, the yield rises and the credit premium re-establishes itself.
This is why bond prices often fall when interest rates rise. Simply put, last week's old bonds paying lower rates aren't as valuable as this week's shiny new bonds paying higher rates.
Okay, back to stocks.
*hypothetical example only.
For stocks, things are a little harder to clearly understand.
You see, stocks can go either way because a stock’s price depends on both future cash flows to investors and the amount of additional compensation a stock investor wants to receive in exchange for the risks they adopt. When interest rates rise, stock investors may feel like they can get better returns in less risky investments, so there's potential to exit stocks in favor of bonds or instead buy different stocks with cash flow or expected return considerations that the investor believes is better positioned to reward them for taking the risk.
However, it is also possible that when interest rates change, expectations about future cash flows expected from holding a stock also change. For example, what if an unprofitable company has relied on cheap loans to be able to finance its growth? This can cause challenges as borrowing costs (interest rates) rise. Unlike bonds, there is no apples-to-apples, standalone theory to follow, so what can we learn from the data?
Research examines the correlation between monthly US stock returns and changes in interest rates.3 The chart below shows that there is no clear pattern relating to stock returns and interest rates (The Federal Funds Rate.4)
Let me break down this chart a little bit...
Each of the teal dots on this chart represents a month of US Stock Market returns. The north-south running Y Axis of this chart shows the % increase or decrease in the Federal Funds Rate (which, for the sake of this writing we'll consider as the only interest rate that matters) and the east-west running X Axis of this chart shows the % increase or decrease in the stock market.
If, for example, a rise in the Federal Funds Rate were a reliable indicator of bad US Stock Market returns, we would expect to see a lot of teal dots in the upper-left quadrant of this chart. Or, conversely, if we thought that rising rates was good for stocks, we would expect to see a lot of dots in the upper-right quadrant. Similarly, if we believed falling rates are indicative of bad stock returns we would expect dots in the lower-left quadrant or if falling rates were good for stock returns we'd expect to see dots in the lower-right quadrant.
The smattering of dots on this chart should highlight there are certainly some outlier months with exceptional patterns, but that the majority of the time the returns and interest rate relationship is clustered toward to the center of the chart with no reasonable pattern to try to exploit.
So, going back to the initial question: when rates go up, do stock prices go down? The answer is yes, but only about 40% of the time. In the remaining 60% of months, stock returns were positive. This split between positive and negative returns was about the same when examining all months, not just those in which rates went up.
So, in other words, there is not a clear relationship between stock returns and interest rate changes.
Once again, this is another "in light of uncertainty, do nothing" sort of blog from Adam. But I think there's some value in highlighting how much work goes into doing nothing when things get scary or uncertain. It doesn't take long to find someone willing to give you a doomsday opinion and a definitive strategy to help you avoid a certain downfall. This clearly isn't my firm's message. We follow the research and prioritize sensibilities over sensationalism.
As Charlie Munger (famous investor and right-hand-man to Warren Buffett) stated earlier this week, "The investment banking profession will sell ‘sh*t’ as long as ‘sh*t’ can be sold."
I agree with this.... and when you have Charlie Munger and Warren Buffett's track record you can drop a bit of profanity without getting people too riled up.
We hope you find this valuable, thanks for reading.
Research source: Dimensional Fund Advisors
Past performance not indicative of future results. For informational purposes only.
1See, for example, Fama 1976, Fama 1984, Fama and Bliss 1987, Campbell and Shiller 1991, and Duffee 2002.
2Wei Dai, “Interest Rates and Equity Returns” (Dimensional Fund Advisors, April 2017).
3US stock market defined as Fama/French Total US Market Index.
4The federal funds rate is the interest rate at which depository institutions lend funds maintained at the Federal Reserve to another depository institution overnight.
Adam Harding, CFP® firstname.lastname@example.org 6026109545 Harding Investments & Planning
Advisor / Owner
1US market is defined as Fama/French Total US Market Research Index.
2Facebook, Amazon, Apple, Netflix, and Google are often referred to as the FAANG stocks.
3Calendar year 2020 data is updated only through November 2020.
Fama/French Total US Market Research Index: The value-weighed US market index is constructed every month, using all issues listed on the NYSE, AMEX, or Nasdaq with available outstanding shares and valid prices for that month and the month before. Exclusions: American depositary receipts. Sources: CRSP for value-weighted US market return. Rebalancing: Monthly. Dividends: Reinvested in the paying company until the portfolio is rebalanced.
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Rising Rates Ain't So Great, Right?
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