Higher Rates May Drive Equity Markets Higher

Includes: AGG, SPY
by: Robert Wagner

What I've always found fascinating about economics and the markets are their often counterintuitive nature. Some time something will occur that will drive a market higher, and then at other times the exact same event will drive the market lower. Some times good news is welcomed and drives a market higher, other times good news is used as an opportunity to take profits and drive the markets lower. Some times lower unemployment is viewed as a positive as an economy emerges from a deep recession and the markets begin to discount a recovery and higher earnings, other times the markets will sell off with a positive jobs report as the markets begin to discount higher inflation.

It is this fact that the markets don't have a single rule book that makes economic and financial analysis so difficult. The gold bugs are discovering this fact out the hard way right now as the markets are proving that printing money doesn't always cause inflation and drive gold higher. The lack of a single rule book also helps explain the rotational nature of the markets, the rolling bubbles, why funds often go from a Morningstar 5 Star Rating to a 1 Star Rating, and back again in a relatively short time period, and why a hot hedge fund manager suddenly goes cold. Trying to predict the markets is like trying to follow and ever changing map, where one day you are on the right track flying down a highway and then the next day there is road construction and you are stuck in traffic.

The best way to explain why markets behave like this is through a calculus analogy of the second derivative. Markets are like functions that have inflection points or points of no return, beyond which the rules change. To the left of the inflection point of a cost curve, increasing production increases profit margins, to the right of it, increasing production reduces the profit margin. The best examples of this I can find are Christopher Columbus deciding that the shortest route to the East was by sailing west, and Doc giving Lightning McQueen the advice "to go right you have to turn left" in the Pixar movie Cars as he explains the counterintuitive physics of a dirt track vs an asphalt track.

Right now we may be witnessing one of those counterintuitive periods of the markets. Historically higher interest rates have pulled money out of the equity markets, driving them lower as higher interest rates squeezed earnings and higher yields on bonds made them more attractive. That is the normal reaction to higher interest rates for an economy and market well into the recovery phase, where the higher interest rates are likely being driven by the fear of inflation. Today we have the exact opposite situation. Higher interest rates from this unusually low level most likely won't squeeze profits, aren't the result of markets discounting inflation but instead are the response of the markets discounting a recovery which most likely will result if stronger earnings in the future even with higher interest rates. If this is the case, higher interest rates may actually be a catalyst to drive equity markets higher. As this video highlights, I'm not alone in considering this theory.

Another analogy applicable to today's market is squeezing a balloon. A balloon has a fixed volume, but the shape is not, so as you squeeze one area, another area balloons out. Markets are very much like that, but they are virtual balloons filled with money. As one sector gets squeezed, the money flows from that sector to another. As interest rates increase, bond prices will fall, squeezing bond holders. As the bond holders get squeezed, they are likely to sell their bonds. If the economy is in fact in the early stages of recovery, and equity yields are improving, that money may counterintuitively flow from the bond market to the equity markets, driving equities higher and bond prices fall. With equities headed higher, the opportunity cost of holding cash will also increase, so people may exchange their cash for the higher return of equities as cautious investors shift from risk off to risk on and optimism replaces pessimism. Lastly, safe haven investments like gold and silver will be squeezed resulting in people selling their security blankets as confidence returns and taking risk becomes more fashionable.

In conclusion, contrary to popular belief, increasing interest rates may actually be good for equities. Higher interest rates will signal to the market that the recovery is for real, and as a result earnings should be improving. Higher rates will also make it difficult for investors to hold longer-term bonds, cash and safe haven investments like gold and silver. When those investments are sold, at least part of that money is likely to find its way into the equity markets. If this theory is correct, investors can expect higher interest rates to drive equity prices higher as long as they don't pass the inflection point where the expectation of higher inflation is a greater concern than improving recovery and increasing earnings, and in my opinion that is a very long way off.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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