Higher Interest Rates Good for Stocks

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Until 1981 interest rates had risen for 4 decades and since then yields are in their 4th decade of decline and ironically rates are back near 2% where they began in the 1940’s. Rising interest rates pump fear through the veins of stock market forecasters and wealth managers, but do rising bond yields really indicate doom for this equity Bull market? Money managers are often stuck in the past, in an era like the 1970’s when the world converted to free floating currencies and battled the painful arthritis of double-digit inflation and falling real stock market returns. The fiat currency shock and inflation of the ’70’s gave us 20% interest rates in order to kill our monetary addiction. Adjusting to a free floating dollar currency in the 1970’s was more the exception than the rule where stocks and bond yields had an inverse relationship. Rising rates should not be feared as yields and stocks often move in unison. We just have to get used to the fact that prior to this massive 35-year decline in bond yields we had an equally massive secular rise in rates where stock prices rose throughout both periods.

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long term bond chart

Interest rates are a measure of the cost of money and economic conditions. Rates rise and fall with the economy as inflation expectations and borrowing demand ebbs and flows. Rising interest rates will increasingly apply brakes to the economy and risk-on-assets such as stocks. Famed billionaire bond guru Bill Gross, who in 2009 correctly coined the “New Normal” decade of sub-par economic growth, has stated recently “I don’t like bonds, I don’t like most stocks.” The $1.5 Billion money manager feels that the bond bubble has burst which is good for gold and bad for stocks. For Gross, the 2.6% yield on the 10 Year Note is his line in the sand where investors should avoid stocks. Janus Fund guru Gross has been Bearish on stocks well before this Trumpian Bull market phase began on November 8th. The fact is interest rates and stocks have been moving in lock step, up and down. Why would this change? Expectations of accelerating earnings growth allow borrowing costs and stock prices to rise simultaneously. Once the economy is overheating with excessive growth, then we can worry more about elevated interest rates and the credit cost of money.

2017 stock bond rates

Is this a fluke? No, rising stock values and rising rates often occur together as it’s a sign of animal spirits in an economy with both rising inflation and stock market earnings per share. With 35 years of “falling” interest rates, it’s harder to associate long term trends of stocks and bonds moving in sync. Since the baby boom inflation peak in 1981 bond yields just keep falling.

Dow Interest Rates 2014

Hearkening back to the halcyon growth era of the 1950’s and ’60’s we also see how common it is for bond yields and stock prices to move in tandem. As long as stock market earnings grow faster than inflation, equities can move up with bond rates. Corporate profits more than doubled in the 1950’s as yields rose from 2.9 to 4.7% and stocks rose by two-thirds.

1950's dow interest rates

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Like the ’50’s, stock market earnings per share more than doubled again in the 1960’s sending stocks sharply higher along with bond yields and lending costs.

Bonds srocks 1960's

Nothing here advises ignoring interest rates potential adverse effect on the economy, corporate profits or the stock market. Rising rates are the primary braking mechanism our capitalist monetary system employs to allocate capital and tame excessive speculation. A normal expansion phase features an economy and inflation that grow with stock and bond rates until a point when interest rates and credit tightening reduce the desire to consume causing a deleveraging phase of economic contraction (Recession). Typically interest rates rise because the economy is healthy. Falling yields are when you should be concerned. Here we can see that most periods in history witnessed good stock market returns while rates rose.

rising rates and stocks table

Currently, household debt service ratios are the lowest in over 40 years, corporations have record levels of unused cash with business credit debt to value ratios near 70-year lows, banks have excess liquidity and the cost of credit is extremely cheap historically. This is not a time to panic about interest rates. Like Bill Gross, we also had warned of short-term resistance once the 10 Year Treasury Note reached the 2.5 to 2.6% zone (3.1 – 3.25% on 30 Yr), but stocks can still rise when yields move above this to their next point of medium-term concern at 3% on 10 Year yields. Remain heavily invested in the stock market and expect higher interest rates.

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