What Do Interest Rates Have to Do With Stock-Market Returns?

Many investors fear that stock prices will plunge when the Fed raises interest rates to “normal levels.” Others say, not to worry, the Fed only controls short-term interest rates, and stock prices depend on long-term rates. Yet others argue that, even if long-term rates do rise, the historical correlation between stocks and bonds is very loose.

Who is right? These arguments are all reasonable, but divert attention from what should matter to value investors.

It is certainly true, other things being equal, that higher interest rates make stocks (and bonds) less valuable.

It is certainly true that the Fed directly controls short-term interest rates, while long-term rates depend on anticipated future Fed policies, inflation expectations, and more.

It is certainly true that the historical correlation between stocks and bonds is weak.

There is not a simple relationship between stock prices and any single factor, including interest rates. The three main drivers of the stock market are the profits companies generate, the long-term interest rates used to discount these profits, and the mood of the market (what Keynes called “animal spirits”). Setting aside irrational animal spirits, let’s focus on the big two: corporate profits and interest rates.

High profits are good for stocks, high interest rates are bad. Sometimes, profits and interest rates move in the same direction—up or down—and the effects on the stock market partly offset each other. Other times, profits go up and interest rates go down (a double boost to stock prices), or profits may go down while interest rates go up (a double whammy for stock prices).

For example, the rate of inflation was above 13 percent in 1979 when Jimmy Carter appointed Paul Volcker Chair of the Federal Reserve. The Fed increased interest rates to unprecedented levels in an all-out war on inflation. When Volcker was asked if these tight-money policies would cause an economic recession, he replied, “Yes, and the sooner the better.” In another conversation, he said that he wouldn’t be satisfied “until the last buzz saw is silenced.” What Volcker meant was that he wanted raise interest rates high enough to choke off borrowing and shut down the building industry.

In 1981, interest rates reached 18 percent on home mortgages and were even higher for most other loans. As interest rates rose, households and businesses cut back on borrowing and purchases of automobiles, homes, and office buildings. Construction workers who lost their jobs were soon spending less on food, clothing, and entertainment, sending ripples through the economy. Farmers with expensive loans and declining income drove tractors into downtown DC to blockade the Federal Reserve Building. The unemployment rate rose from 5.8 percent in 1979 to above 10 percent in 1982, the highest level since the Great Depression, but the Fed’s scorched-earth policy reduced the rate of inflation from above 13 percent in 1979 to below 4 percent in 1982.

When the Fed raises interest rates to fight inflation by crippling the economy, bond and  stock prices generally fall. Since bond and stock returns both fall, they are positively correlated.

After getting the inflation rate below 4 percent in 1982, the Fed began lowering interest rates in order to save the banking system and the economy. Now bond and stock markets both did well, again giving a positive correlation between their returns.

On the other hand, bond and stock returns have mostly been negatively correlated since 2000. As the economy slid into the Great Recession, the stock market crashed while the Fed lowered interest rates (boosting bond prices) in order to keep the Great Recession from turning into the Second Great Depression. As the economy recovered, interest rates rose modestly (hurting bond returns), while the stock market surged—a negative correlation between stock and bond returns.

The figure below shows rolling correlations between the monthly returns on the S&P 500 and long-term Treasury bonds from 1926 (as far back as these data go) through 2016. For each month, the correlation was calculated between the monthly returns over the preceding five years. For example, the December 2016 number (-0.37) is the correlation between monthly bond and stock returns over the five-year period January 2012 through December 2016.

The average correlation over nearly a century has been 0.09, but the correlation has been extremely variable, fluctuating between -0.64 in March 2015 and 0.59 in November 1994. There have been many years when stocks and bonds both did well, many years when they both did poorly, and many years when one did well and the other poorly.

Putting together the loose connection between short-term and long-term interest rates and the loose connection between long-term rates and stock prices, it is clear that trying to forecast stock prices based on predicted changes in short-term interest rates is hazardous to one's wealth.

The real question right now is not whether interest rates are going up (they probably are), but whether an increase in long-term interest rates is more likely be accompanied by a weaker or stronger economy. If the Fed were to raise interest rates enough to cause an economic recession (like Volcker did), that would be bad for stocks (and bonds). If on the other hand, the Fed were to allow interest rates to rise because the economy was getting stronger and the Fed did not want to unleash the dogs of inflation, the net effect on the stock market would be modest and might even be positive.

Knowing Janet Yellen (we were classmates at Yale and students of Nobel Laureate James Tobin), I think that the latter scenario is far more likely. If an increasingly strong economy threatens to push the core rate of inflation above 2 percent, the Yellen Fed is likely to let interest rates rise, but will not push the economy into a serious economic recession.

Oh, one more thing. Value investors should not be obsessed with predicting short-term movements in interest rates or stock prices. The question right now for value investors is whether a long-run annual return on stocks of 5 to 7 percent, compared to 2 to 3 percent on Treasury bonds, is reason enough to stay in the market.

It would be foolish to try to time the market by predicting interest rates and guessing whether stock prices will be higher or lower tomorrow, a week from now, or six months from now.

Instead, think of this question: if you were to buy stocks or bonds today, which do you think will generate more income over the next 10, 20, or 30 years? Your answer will tell you which to buy.