Do Rising Rates Really Signal Strong Growth and Rising Equity Prices?

Includes: DIA, QQQ, SPY
by: The Fundamental Analyst

The current fad of those on Wall Street is that rising interest rates are signaling strong economic growth and thus will lead to rising equity prices. Looking at the correlation over the past decade between interest rates and equity prices it would seem that thesis has some merit. However, as the latest monthly commentary from the Contrary Investor points out, the 40 year period from 1960 – 2000 tells a very different story.

Where a correlation exists between equity prices and interest rates (indicated by the 10 year treasury) during that period, it has overwhelmingly been a negative one. For example during the 1980′s the only time equity prices and interest rates moved in a positively correlated fashion, ie they both went up together, was in 1987 and we know how that worked out. Similarly the only time in the 1990′s that interest rates and equities went up together was 1999.

Thus the latest Wall Street fad is predicated on the back of the previous decade that saw equities cut in half twice and a generational plunge in home prices. Is it a coincidence that the entire period of the last decade where a positive correlation between equity prices and interest rates existed was one in which the Fed was overly accommodative? Or less politely put, blowing bubbles? Is that not what we have now, as the Greenspan put has seamlessly transitioned into the Bernanke put?

Another important point from the contrary investor worth considering before buying into the ‘rising rates equals strong economic recovery’ story:

If you bring the TIPS yields into the analysis and look at the trajectory of inflation breakeven rates, it is absolutely clear investors are pricing in higher inflation with the higher interest rates we have seen as of late as opposed to supposedly pricing in a big improvement in the domestic economy. The Street seers don’t seem to bring this into the analysis at all when pointing to how bullish a sign higher interest rates supposedly are for equities.

So sure, with Fed policy now officially aimed at raising equity prices, we can envisage a period of time when interest rates and stocks can rise in tandem. However we’ve seen this movie enough times before to know that it never ends well.