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The Effect of Rising Rates on Equities

The Effect of Rising Rates on Equities

| October 23, 2018

In late September, the Federal Reserve raised the level for its target benchmark to 2.00%-2.25%.  This is the third rate hike by the Fed this year.  They also signaled rates will rise again in December.  While rates are still historically low, it has been a long time since we have seen this level.  There is a lot of discussion about how rates will affect the economy, but the real question is how rates will affect equities because they tend to lead the economy.  By the time any recession has been identified, equities have generally moved well before.

The first thing to remember is that rising rates do not automatically spell doom for the stock market.  This fact often gets lost in the incessant search for headlines by the financial media.  Interest rates initially begin to rise because the economy is improving, and that is a good thing for equities.  Eventually, rates go too high and it begins to choke off economic growth.  The interest rate level where equities are affected has actually been fairly well defined historically.  The chart below from JP Morgan Asset Management shows correlation coefficients for weekly S&P 500 returns versus 10-year Treasury yields from 1963.  When rates are low, the S&P 500 typically goes up when rates go up.  The tipping point is clearly defined by the orange line at 5.0%.  Currently, the 10-year Treasury yield is at 3.24%, so we have quite a ways to go until we get to that 5.0% level.  The current tightening cycle is not automatically a bad thing for equities, and should not be used as an excuse to stay out of the market at these levels.



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