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Investing During Rising Interest Rates

Success in business.

 

By: Bill Boyd, CFA®

In a speech on “Normalizing Monetary Policy” on 3/27/15, Janet Yellen, chairwomen of the Federal Reserve Board (FED), laid out in some detail the FED’s current expectations for economic growth and interest rates over the next several years.

She said she expects that economic “conditions may warrant an increase in the federal funds rate target (1) sometime this year”, that the rising rate cycle is likely to last “over the next several years”, that rates are projected to “increase at 1.0% a year on average through the end of 2017”, and reach their long-run “normal” level of about 3.5% to 4.0% by the end of 2018. On economic growth, she said “I anticipate that real (inflation adjusted) gross domestic production (GDP) is likely to expand somewhat faster than its (long-run) potential in coming quarters”. (2)

Since higher interested rates normally accompany a growing economy, and a growing economy usually leads to higher corporate earnings, which are the engine that drives stock prices highs, we took Ms. Yellen’s comment as good news for business owners (IE Stockholders). However, there seems to be a widely held assumption among many economists and investors that higher interest rates will bring an end to our 6 years bull (rising) market and possibly even put us back in recession. (3)

We do not agree with this assumption. Not because we don’t think that “high” interest rates would hurt stock prices, they would. But because we don’t think that “normal” interest rates will hurt stock prices. And a return to “normal” is all the FED has indicated they intend to do and even that won’t occur until the end of 2018, over 3 years away.

How high would interest rates likely have to rise before they begin to significantly affect stock prices? A number of studies have been done on this question. One going back well over 100 years plus study found that “trouble for the stock market appears to kick in only when 10 years treasury bonds are yielding 6.0%  or higher. Below that level, the correlation between the two has been virtually zero.” (4) The 60 years studies found that the negative affect on stock prices began once 10 years treasury rates rose above 5.0% (5). We are not aware of any studies that conclude that rates below 5.0% adversely affect stock prices.

So how high are rates on 10 year treasury bonds reasonably likely to go during the FED’s coming rate rising cycle? According to the Federal Reserve Bank of St. Louis, the yield on the 10 years treasury bond averaged 4.64% from 1871-2011 (140 years). (6)  That was an average of 2.57% above inflation rate for the period.

 

With the FED now officially targeting 2.0% inflation and 10 year treasury’s historically yielding 2.57% above the inflation rate, it seems highly probable that the “normal” 10 year treasury yield should average somewhere around 4.50% over coming years- not high enough to adversely affect stock prices according to the studies discussed above.

So stock prices should continue to be driven by earning growth and the valuation (price/earnings ratio) that investors place on these earnings, with no significant headwind likely from high interest rates. High inflation and high interest rates are the most common causes of recession and bear markets. Both are current below “normal” and they are not expected (by the FED) to return to “normal” until at least the end of 2018.

So for the stock (business ownership) position of investors portfolio’s, we would stick with high-quality, dividend paying stocks and ignore, to the extent that we can, the recession and beas (declining) market prognosticators.

 

Content in this material is for general information only and not intended to provide specific   advice or recommendations for any individual. The payment of dividends is not guaranteed.  Companies may reduce or eliminate the payment of dividends at any given time.   No strategy assures success or protects against loss. Stock investing involves risk including loss of principal.

 

 

 

 

 

 

Footnotes:

  • Federal Funds are commercial bank deposits at the FED. The interest rate paid on these funds is called the Federal Funds Rate.
  • The FED currently estimates GDP’s long-run potential growth at 2.0%-2.3% average annually. Chairwomen Yellen projects growth will be “somewhat faster than that in coming quarters”.
  • “The FED… may be setting us up for recession. Raising rates could make things worse.” (Timothy Day, Director of the Oregon Economic Forum at the University of Oregon. Bloomberg Business 8/13/15).
  • Doug Ramsey, Chief Investment Officer at the Leuthold Group, N.Y. Times 6/1/2013.
  • CNN Money Magazine 5/31/13 and N.Y. Times 6/1/13.
  • Louis Federal Reserve Bank 10 year Constant Majority Rates.