Will Higher Interest Rates Ruin the Stock Rally?

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More than five years have passed since the Federal Reserve announced its first round of large-scale asset purchases. The central bank quickly followed the move by implementing a zero interest rate policy. An extremely accommodative monetary stance has been a staple in the financial system ever since. With the latest quantitative easing program on pace to end this year, investors are shifting their focus toward rising interest rates. However, do higher rates indicate trouble for stocks?

It appears the day is finally approaching when the Federal Reserve can stop holding Mr. Market’s hand so tightly. At its first meeting under new Fed Chair Janet Yellen, the central bank continued to dial down its monthly bond purchases by $10 billion. It will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month and longer-term Treasury securities at a pace of $30 billion per month. If the current pace of tapering continues, the open-ended QE program could conclude in December.

The Federal Open Market Committee said: “The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases.” The changes will begin in April.

The FOMC also dropped the linkage between the headline unemployment rate and its benchmark interest rate, known as the Evans Rule, but said it intends to keep short-term interest rates at record lows for a “considerable time after” QE ends. However, the real fun began when Yellen was asked to clarify that statement during her news conference. She explained that it probably means interest rates could start to rise “around six months.” Depending when the Federal Reserve ends QE, this means rates could begin to climb around June 2015.

Yellen’s statement caught the market off guard. The Dow Jones Industrial Average quickly fell more than 200 points following her remarks before ultimately finishing the day down 114 points. The yield on the 10-year Treasury also approached 2.78 percent. Some market participants believe Yellen misspoke when she defined the timeline as around six months, but it at least reminded investors that interest rates cannot stay low forever.

Conventional wisdom says that over the past 60 years, rising rates have been trouble for the stock market. According to S&P Dow Jones Indices, since April 1953 through June 2013, the average monthly return of the S&P 500 has been 0.94 percent. During this period, there were 347 months when the 10-year Treasury declined and 358 months when it increased. When the 10-year Treasury declined, the S&P 500 averaged a monthly gain of 1.38 percent compared to only 0.63 percent in months the 10-year Treasury rose — less than half of the return.

Furthermore, in the months when 10-year Treasury rates increased the most, the S&P 500 fell by an average of 0.12 percent, representing the only period in which stocks declined on average. However, in the 173 months when interest rates declined the most, the S&P 500 posted its best monthly performance (1.5 percent on average). Nonetheless, the Federal Reserve’s unprecedented actions in recent years have distorted the financial landscape. Between 1998 and 2012, falling rates were associated with a rising stock market only 27 percent of the time.

“Whatever happens next to interest rates won’t happen by accident, but by the considered decision of the Federal Open Market Committee,” said Craig Lazzara, global head of index investment strategy for S&P Dow Jones Indices, in a recent report. “That said, to what degree should the prospect of Federal Reserve tapering unsettle equity investors? The evidence does not allow a definitive answer. There are good historical reasons to believe that the prospective increase in interest rates will be bad for the stock market, but there are also reasons to believe the opposite.” Lazzara notes that if the economy begins to perform better, stocks could potentially rise along with interest rates as the outlook for earnings growth improves.

In the end, investors should remember that the Federal Reserve has expanded its balance sheet to more than $4 trillion to help stabilize the financial system. It’s also still trying to repair its reputation from the disastrous housing bubble that it ignored until it was too late. The central bank will raise its benchmark interest rate at some point in the future, but it will be a gradual increase so it does not cause catastrophic shockwaves in the stock market. Although, that doesn’t mean another issue that’s currently being ignored  won’t cause a significant correction in stocks.

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