What's likely to happen to stocks if/when interest rates rise?

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Lauretta
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What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 3:38 am

I hear people in the investment industry saying that the stock market is not overvalued, considering the current level of interest rates.
This would seem to imply that if/(when) rates go up, stock prices should go down accordingly. I also recall reading a piece by Buffett in which he compares interetest rates to gravity; the more they increase, the more they bring the prices of risky assets down (which is logical, since people should expect greater returns than the risk free rate for them!...).
However I've also seen arguments saying for example that rate hikes would be interepreted as a sign that the economy is in good health, so they would not adversly affect the stock market.
So I'm not sure how to think about the relationship between interest rates and stocks. I guess what also counts is the speed at which rates are eventually hiked? (i.e. is the rate of increase of the rates - sorry for the terrible pun ;-) - the important parameter? ) Would be interested in your take on this!
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by The Wizard » Thu Sep 14, 2017 4:17 am

Small rate increases don't seem to negatively impact stock prices much. We've had a few lately.

But if rate increases continue, then bonds start looking increasingly attractive for new money. And it costs companies more to borrow.
So this will tend to depress stock prices...
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 4:37 am

The Wizard wrote:
Thu Sep 14, 2017 4:17 am
Small rate increases don't seem to negatively impact stock prices much. We've had a few lately.

But if rate increases continue, then bonds start looking increasingly attractive for new money. And it costs companies more to borrow.
So this will tend to depress stock prices...
thanks :happy so it seems to be a question of the extent to which rates increase, more than the speed at which they increase
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FIREchief
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by FIREchief » Thu Sep 14, 2017 5:07 am

Please specify real interest rates or nominal interest rates.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by AlohaJoe » Thu Sep 14, 2017 5:12 am

Lauretta wrote:
Thu Sep 14, 2017 4:37 am
The Wizard wrote:
Thu Sep 14, 2017 4:17 am
Small rate increases don't seem to negatively impact stock prices much. We've had a few lately.

But if rate increases continue, then bonds start looking increasingly attractive for new money. And it costs companies more to borrow.
So this will tend to depress stock prices...
thanks :happy so it seems to be a question of the extent to which rates increase, more than the speed at which they increase
Large increases also don't seem to matter. From 2004 to 2006 the effective Fed rate went from 1.38% in June 2004 to 5.31% in July 2006. 4% increase in 24 months.

The Wilshire 5000 went from 38.47 to 45.59 over that same period. So even a dramatic rate increase still saw a price-only return of 18%. Then throw in dividends and the return goes up even more.

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 5:20 am

FIREchief wrote:
Thu Sep 14, 2017 5:07 am
Please specify real interest rates or nominal interest rates.
I'd say I'm interested in the effect of both, though I was thinking nominal when I wrote the above.
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 5:30 am

AlohaJoe wrote:
Thu Sep 14, 2017 5:12 am
Lauretta wrote:
Thu Sep 14, 2017 4:37 am
The Wizard wrote:
Thu Sep 14, 2017 4:17 am
Small rate increases don't seem to negatively impact stock prices much. We've had a few lately.

But if rate increases continue, then bonds start looking increasingly attractive for new money. And it costs companies more to borrow.
So this will tend to depress stock prices...
thanks :happy so it seems to be a question of the extent to which rates increase, more than the speed at which they increase
Large increases also don't seem to matter. From 2004 to 2006 the effective Fed rate went from 1.38% in June 2004 to 5.31% in July 2006. 4% increase in 24 months.

The Wilshire 5000 went from 38.47 to 45.59 over that same period. So even a dramatic rate increase still saw a price-only return of 18%. Then throw in dividends and the return goes up even more.
ah ok thanks :happy so it looks like the relationship is very complex and probably depends on lots of other parameters
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Sammy_M » Thu Sep 14, 2017 5:49 am

Growth stocks don't look as good. See W. Berstein's "Of Mines, Forests, and Impatience".
http://www.efficientfrontier.com/ef/401/fisher.htm

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 6:01 am

Sammy_M wrote:
Thu Sep 14, 2017 5:49 am
Growth stocks don't look as good. See W. Berstein's "Of Mines, Forests, and Impatience".
http://www.efficientfrontier.com/ef/401/fisher.htm
Thanks! :happy It looks very interesting and intelligently written. I came across this sentence though: 'However, money rates of interest are never negative.' It's not what's happening today in Europe and Japan!
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Sammy_M » Thu Sep 14, 2017 6:07 am

Lauretta wrote:
Thu Sep 14, 2017 6:01 am
Sammy_M wrote:
Thu Sep 14, 2017 5:49 am
Growth stocks don't look as good. See W. Berstein's "Of Mines, Forests, and Impatience".
http://www.efficientfrontier.com/ef/401/fisher.htm
Thanks! :happy It looks very interesting and intelligently written. I came across this sentence though: 'However, money rates of interest are never negative.' It's not what's happening today in Europe and Japan!
Money is italicized because he is emphasizing nominal rather than inflation adjusted. Nominal rates never go negative, but inflation adjusted rates do.

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by The Wizard » Thu Sep 14, 2017 6:25 am

Answer depends on inflation rate as well.
If savings accounts were paying 5% today with inflation as it is, then lots of $$ would exit stocks and bring prices down.

But that's not how it works. Inflation tends to increase along with interest rates...
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 6:27 am

Sammy_M wrote:
Thu Sep 14, 2017 6:07 am
Lauretta wrote:
Thu Sep 14, 2017 6:01 am
Sammy_M wrote:
Thu Sep 14, 2017 5:49 am
Growth stocks don't look as good. See W. Berstein's "Of Mines, Forests, and Impatience".
http://www.efficientfrontier.com/ef/401/fisher.htm
Thanks! :happy It looks very interesting and intelligently written. I came across this sentence though: 'However, money rates of interest are never negative.' It's not what's happening today in Europe and Japan!
Money is italicized because he is emphasizing nominal rather than inflation adjusted. Nominal rates never go negative, but inflation adjusted rates do.
Ah ok. Sorry I am a beginner in this so this question might be silly, but what is the difference between the money rate and the y-axis intercept of the yield curve? (The latter is negative in many places today) Thanks
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by AlohaJoe » Thu Sep 14, 2017 6:29 am

Sammy_M wrote:
Thu Sep 14, 2017 6:07 am
Lauretta wrote:
Thu Sep 14, 2017 6:01 am
Sammy_M wrote:
Thu Sep 14, 2017 5:49 am
Growth stocks don't look as good. See W. Berstein's "Of Mines, Forests, and Impatience".
http://www.efficientfrontier.com/ef/401/fisher.htm
Thanks! :happy It looks very interesting and intelligently written. I came across this sentence though: 'However, money rates of interest are never negative.' It's not what's happening today in Europe and Japan!
Money is italicized because he is emphasizing nominal rather than inflation adjusted. Nominal rates never go negative, but inflation adjusted rates do.
Nominal rates definitely go negative. Why would you make such a strange claim? My German bank account has negative nominal and real rates right now. They subtract money every month.

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 6:31 am

The Wizard wrote:
Thu Sep 14, 2017 6:25 am
Answer depends on inflation rate as well.
If savings accounts were paying 5% today with inflation as it is, then lots of $$ would exit stocks and bring prices down.

But that's not how it works. Inflation tends to increase along with interest rates...
thanks. so this means that if rates increase with inflation, people are not likely to exit the market even if rates are higher, because in real terms they won't get more. So in this case stocks should not drop in price. Is that roughly what you meant?
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 6:34 am

AlohaJoe wrote:
Thu Sep 14, 2017 6:29 am
Sammy_M wrote:
Thu Sep 14, 2017 6:07 am
Lauretta wrote:
Thu Sep 14, 2017 6:01 am
Sammy_M wrote:
Thu Sep 14, 2017 5:49 am
Growth stocks don't look as good. See W. Berstein's "Of Mines, Forests, and Impatience".
http://www.efficientfrontier.com/ef/401/fisher.htm
Thanks! :happy It looks very interesting and intelligently written. I came across this sentence though: 'However, money rates of interest are never negative.' It's not what's happening today in Europe and Japan!
Money is italicized because he is emphasizing nominal rather than inflation adjusted. Nominal rates never go negative, but inflation adjusted rates do.
Nominal rates definitely go negative. Why would you make such a strange claim? My German bank account has negative nominal and real rates right now. They subtract money every month.
Didn't know they did that in Germany! Italy and France are lucky to get roughly zero then! (except that probably Germany is safer, which would explain the situation)
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by alex_686 » Thu Sep 14, 2017 6:49 am

The value of a stock is Free Cash Flow to Equity (FCFE). This cash flow needs to be discounted by time. "Discounted" = interest rates. If real interest rates increase then the discount rate increases which mean stock prices fall.

If interest rates increase due to inflation, then not much. Stocks are a good hedge.

If we revert back to a more historical normal situation than stocks will fall. If it slowly reverts we may not even notice. That being said, CAPE 10 et. al. does not have a mean reverting property.
So who knows.

That being said we do need to keep one eye out on growth. If expected FCFE increases than stock prices will also increase. Take a look at the 90s. Increased productivity lead to a increase demand in investments, which lead to a increase in both interest rates and stock prices.

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by The Wizard » Thu Sep 14, 2017 7:12 am

Lauretta wrote:
Thu Sep 14, 2017 6:31 am
The Wizard wrote:
Thu Sep 14, 2017 6:25 am
Answer depends on inflation rate as well.
If savings accounts were paying 5% today with inflation as it is, then lots of $$ would exit stocks and bring prices down.

But that's not how it works. Inflation tends to increase along with interest rates...
thanks. so this means that if rates increase with inflation, people are not likely to exit the market even if rates are higher, because in real terms they won't get more. So in this case stocks should not drop in price. Is that roughly what you meant?
Well, it's complicated. People have different risk/reward ratios.

I think higher interest rates will impact certain companies more than others, probably value companies will see additional expense on their corporate bonds which will keep dividends lower, thus holding stock prices of those companies down.

But a growth stock company like Apple, with $250 billion in cash might even benefit from higher interest rates...
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Simplegift » Thu Sep 14, 2017 9:51 am

Lauretta wrote:
Thu Sep 14, 2017 3:38 am
So I'm not sure how to think about the relationship between interest rates and stocks.
Several studies of the historical relationship between interest rate changes and stock prices show a “threshold effect” (chart below). When rates are below about 5%, rising rates are correlated with rising stock prices. When rates are above about 5%, rising rates have been correlated with falling stock prices.
  • Image
    NOTE: The x-axis shows the yield of the 10-year U.S. Treasury, and the y-axis shows the 24-month rolling correlation between weekly S&P 500 price returns and changes in the 10-yr U.S. Treasury yield.
    Source: JP Morgan
There might be several explanations for this historical 5% threshold effect (e.g., bonds become more attractive investments than stocks, the cost of capital exceeds the sustainable growth rate of the economy, etc.) — but who knows whether this relationship will still hold in the future, with rates rising from such a low base today.
Cordially, Todd

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 10:42 am

Simplegift wrote:
Thu Sep 14, 2017 9:51 am
Lauretta wrote:
Thu Sep 14, 2017 3:38 am
So I'm not sure how to think about the relationship between interest rates and stocks.
Several studies of the historical relationship between interest rate changes and stock prices show a “threshold effect” (chart below). When rates are below about 5%, rising rates are correlated with rising stock prices. When rates are above about 5%, rising rates have been correlated with falling stock prices.
  • Image
    NOTE: The x-axis shows the yield of the 10-year U.S. Treasury, and the y-axis shows the 24-month rolling correlation between weekly S&P 500 price returns and changes in the 10-yr U.S. Treasury yield.
    Source: JP Morgan
There might be several explanations for this historical 5% threshold effect (e.g., bonds become more attractive investments than stocks, the cost of capital exceeds the sustainable growth rate of the economy, etc.) — but who knows whether this relationship will still hold in the future, with rates rising from such a low base today.
Wow thank you! :happy that's really interesting! I remember the user jbolden (who sadly seems to have disappeared from this Forum) wrote something about a threshold at around 5% last July or August and this questions had been at the back of mind. Just found the JP Morgan file through Google, it has plenty of interesting graphs :-)
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by DrGoogle2017 » Thu Sep 14, 2017 10:46 am

I think we will have the opposite effect of QE easing, QE tightening will cause some problem for stocks. But most likely when interest is about 6%, not lower.
Last edited by DrGoogle2017 on Thu Sep 14, 2017 10:51 am, edited 1 time in total.

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 10:48 am

Simplegift wrote:
Thu Sep 14, 2017 9:51 am

There might be several explanations for this historical 5% threshold effect (e.g., bonds become more attractive investments than stocks, the cost of capital exceeds the sustainable growth rate of the economy, etc.) — but who knows whether this relationship will still hold in the future, with rates rising from such a low base today.
Sorry, one question if I may. I understand your explanations of the negative correlation (above 5%), but what would be the reasons for the positive correlation below that threshold?
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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Simplegift » Thu Sep 14, 2017 11:04 am

Lauretta wrote:
Thu Sep 14, 2017 10:48 am
Sorry, one question if I may. I understand your explanations of the negative correlation (above 5%), but what would be the reasons for the positive correlation below that threshold?
Rising interest rates often indicate the economy is getting stronger, leading to increased demand for loans, increasing interest rates. This is usually good for stocks — but up to a point. If the Fed believes the economy is getting too strong (overheating), leading to increased inflation, they will start raising rates to slow inflation — which has historically been bad for stocks (chart below).
In the chart, notice the stock market rising (due to a strong economy and rising earnings) up to a point, then starting to fall once the Fed funds rate reaches the 5%-6% range. Whether this same dynamic will hold in the future is anyone's guess.
Cordially, Todd

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Re: What's likely to happen to stocks if/when interest rates rise?

Post by Lauretta » Thu Sep 14, 2017 11:06 am

Simplegift wrote:
Thu Sep 14, 2017 11:04 am
Lauretta wrote:
Thu Sep 14, 2017 10:48 am
Sorry, one question if I may. I understand your explanations of the negative correlation (above 5%), but what would be the reasons for the positive correlation below that threshold?
Rising interest rates often indicate the economy is getting stronger, leading to increased demand for loans, increasing interest rates. This is usually good for stocks — but up to a point. If the Fed believes the economy is getting too strong (overheating), leading to increased inflation, they will start raising rates to slow inflation — which has historically been bad for stocks (chart below).
In the chart, notice the stock market rising (due to a strong economy and rising earnings) up to a point, then starting to fall once the Fed funds rate reaches the 5%-6% range. Whether this same dynamic will hold in the future is anyone's guess.
Again, thank you! :happy
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